Multinational Business Finance, 14e (Eiteman)
Chapter 8 Interest Risk and Swaps
8.1 Interest Rate Derivatives
1) ________ is the possibility that the borrower’s creditworthiness is reclassified by the lender at
the time of renewing credit. ________ is the risk of changes in interest rates charged at the time a
financial contract rate is set.
A) Credit risk; Interest rate risk
B) Repricing risk; Credit risk
C) Interest rate risk; Credit risk
D) Credit risk; Repricing risk
2) Individual borrowers — whether they be governments or companies — possess their own
individual credit rating, the market’s assessment of their ability to repay debt in a timely manner.
These credit assessments influence all the following EXCEPT:
A) cost of capital
B) access to capital
C) credit risk premium
D) risk-free rate
3) Historically, interest rate movements have shown less variability and greater stability than
exchange rate movements.
4) Some of the world’s largest and most financially sound firms may borrow at variable rates less
than LIBOR.
5) The London Interbank Offered Rate (LIBOR) is published under the auspices of the British
Bankers Association. A panel of 16 major multinational banks self-report their actual borrowing
rate.
6) The basis point spreads between credit ratings dramatically rise for borrowers of credit
qualities less than BBB.
7) Sovereign credit risk is the global financial market’s assessment of the ability of a sovereign
borrower to repay USD denominated debt.
8) For a corporate borrower, it is especially important to distinguish between credit risk and
repricing risk. Explain both types of risks.
8.2 Foreign Currency Futures
1) The single largest interest rate risk of a firm is:
A) interest sensitive securities.
B) debt service.
C) dividend payments.
D) accounts payable.
Instruction 8.1:
For the following problem(s), consider these debt strategies being considered by a corporate
borrower. Each is intended to provide $1,000,000 in financing for a three-year period.
∙ Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%.
∙ Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset
annually. The current LIBOR rate is 3.50%
∙ Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit
annually. The current one-year rate is 5%.
2) Refer to Instruction 8.1. Choosing strategy #1 will:
A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and
repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.
3) Refer to Instruction 8.1. Choosing strategy #2 will:
A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and
repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.
4) Refer to Instruction 8.1. Choosing strategy #3 will:
A) guarantee the lowest average annual rate over the next three years.
B) eliminate credit risk but retain repricing risk.
C) maintain the possibility of lower interest costs, but maximizes the combined credit and
repricing risks.
D) preclude the possibility of sharing in lower interest rates over the three-year period.
5) Refer to Instruction 8.1. Which strategy (strategies) will eliminate credit risk?
A) Strategy #1
B) Strategy #2
C) Strategy #3
D) Strategies #1 and #2
6) Refer to Instruction 8.1. If your firm felt very confident that interest rates would fall or, at
worst, remain at current levels, and were very confident about the firm’s credit rating for the next
10 years, which strategy would you likely choose? (Assume your firm is borrowing money.)
A) Strategy #3
B) Strategy #2
C) Strategy #1
D) Strategy #1, #2, or #3; you are indifferent among the choices.
7) Refer to Instruction 8.1. The risk of strategy #1 is that interest rates might go down or that
your credit rating might improve. The risk of strategy #2 is: (Assume your firm is borrowing
money.)
A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above
8) Refer to Instruction 8.1. The risk of strategy #1 is that interest rates might go down or that
your credit rating might improve. The risk of strategy #3 is: (Assume your firm is borrowing
money.)
A) that interest rates might go down or that your credit rating might improve.
B) that interest rates might go up or that your credit rating might improve.
C) that interest rates might go up or that your credit rating might get worse.
D) none of the above
9) Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer
strategy #1? (Assume your firm is borrowing money.)
A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.
10) Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer
strategy #2? (Assume your firm is borrowing money.)
A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.
11) Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer
strategy #3? (Assume your firm is borrowing money.)
A) Your credit rating stayed the same and interest rates went up.
B) Your credit rating stayed the same and interest rates went down.
C) Your credit rating improved and interest rates went down.
D) Not enough information to make a judgment.
12) Unlike the situation with exchange rate risk, there is no uncertainty on the part of
management for shareholder preferences regarding interest rate risk. Shareholders prefer that
managers hedge interest rate risk rather than having shareholders diversify away such risk
through portfolio diversification.
13) Interest rate calculations differ by the number of days used in the period’s calculation and in
the definition of how many days there are in a year (for financial purposes). One of the practices
is to use 260 business days in a year.
8.3 Option Pricing and Valuation
1) An interbank-traded contract to buy or sell interest rate payments on a notional principal is
called a/an:
A) forward rate agreement.
B) interest rate future.
C) interest rate swap.
D) none of the above
2) A/an ________ is a contract to lock in today interest rates over a given period of time.
A) forward rate agreement
B) interest rate future
C) interest rate swap
D) none of the above
3) The financial manager of a firm has a variable rate loan outstanding. If she wishes to protect
the firm against an unfavorable increase in interest rates she could:
A) sell an interest rate futures contract of a similar maturity to the loan.
B) buy an interest rate futures contract of a similar maturity to the loan.
C) swap the adjustable rate loan for another of a different maturity.
D) none of the above