Chapter 15—Swap Markets
1. Financial institutions with ____ interest rate-sensitive liabilities than assets are ____ affected by rising
interest rates.
a.
more; adversely
b.
fewer; adversely
c.
more; favorably
d.
none of the above
2. Which of the following statements is incorrect?
a.
Interest rate swaps are sometimes used by financial institutions and other firms for
speculative purposes.
b.
A primary reason for the popularity of interest rate swaps is the existence of market
imperfections.
c.
Swaps are necessary for some financial institutions to obtain the maturities or rate
sensitivities on funds that they desire.
d.
Most financial institutions that anticipate that interest rate will move in an unfavorable
direction to not hedge their positions.
3. Savings institutions participate in the swap market primarily to
a.
serve as an intermediary by matching up two parties in a swap.
b.
serve as a dealer by taking the counterparty position in a swap.
c.
reduce interest rate risk.
d.
none of the above
4. In a swap arrangement, the most common index used for floating-rate payments would be the
a.
coupon rate on existing bonds.
b.
stock dividend rate based on a U.S. stock index.
c.
London Interbank Offer Rate (LIBOR).
d.
Treasury bond yield.
5. The most likely users of plain vanilla swaps would be
a.
commercial banks that focus on short-term consumer loans.
b.
savings institutions.
c.
manufacturing companies.
d.
municipal governments.
6. A plain vanilla swap is especially beneficial when interest rates are expected to
a.
rise consistently.
b.
decline consistently.
c.
be stable.
d.
rise and then decline.
7. Swap transactions are only used to
a.
hedge against upward interest rate movements.
b.
hedge against downward interest rate movements.
c.
speculate.
d.
none of the above
8. If a firm negotiates a plain vanilla swap, it will provide ____ payments in exchange for ____
payments.
a.
fixed-rate; floating-rate
b.
floating-rate; fixed rate
c.
stock dividend; fixed-rate
d.
stock dividend; floating rate
9. A ____ swap allows the party making floating-rate payments to terminate the swap prior to maturity.
a.
zero coupon-for-floating
b.
forward
c.
callable
d.
putable
10. A(n) ____ allows the party making fixed payments to extend the swap period.
a.
forward
b.
extendable
c.
callable
d.
putable
11. A(n) ____ swap allows the party making fixed-rate payments to terminate the swap prior to maturity.
a.
forward
b.
extendable
c.
callable
d.
putable
12. A ____ swap involves the exchange of fixed-rate payments for floating-rate payments that are capped.
a.
rate-capped
b.
zero-coupon-for-floating
c.
callable
d.
putable
13. In a(n) ____ swap, the fixed-rate payer makes a single payment at the maturity date of the swap
agreement, while the floating-rate payer makes periodic payments throughout the swap period.
a.
rate-capped
b.
zero-coupon-for-floating
c.
extendable
d.
callable
14. The option on a callable swap would most likely be exercised if interest rates
a.
rise.
b.
fall.
c.
remain constant.
d.
remain somewhat stable.
15. The option on a putable swap would most likely be exercised if interest rates
a.
rise.
b.
fall.
c.
remain constant.
d.
remain somewhat stable.
16. A(n) ____ swap involves an exchange of interest payments over a swap period that does not begin
until a specified future point in time.
a.
forward
b.
extendable
c.
callable
d.
putable
17. Assume a financial institution that has rate-sensitive liabilities and rate-insensitive assets. If interest
rates are expected to decline consistently, this institution would benefit by negotiating a(n)
a.
forward swap.
b.
callable swap.
c.
extendable swap.
d.
none of the above
18. Assume a financial institution has rate-sensitive liabilities and rate-sensitive assets. If this institution
negotiates a rate-capped swap, its ____ payments will be capped, and it will ____ an up-front premium
in exchange for the cap.
a.
outflow; receive
b.
outflow; pay
c.
inflow; pay
d.
inflow; receive
19. An equity swap involves the exchange of interest payments for payments linked to the degree of
change in a bond index.
a. True
b. False
20. Assume a U.S. savings institution funds its fixed-rate mortgages by attracting short-term deposits. If it
engages in an interest rate swap, but the index on the swap does not move in perfect tandem with its
cost of deposits, this reflects
a.
sovereign risk.
b.
basis risk.
c.
credit risk.
d.
none of the above
21. According to the text, any political aspects that prevent a counterparty on a swap from meeting its
payment obligations represent
a.
sovereign risk.
b.
basis risk.
c.
credit risk.
d.
none of the above
22. ____ risk prevents the interest rate swap from completely eliminating a financial institution’s exposure
to interest rate risk.
a.
Credit
b.
Basis
c.
Sovereign
d.
None of the above
23. ____ risk in a swap is typically not overwhelming because the affected party can simply discontinue
its payments to the other party.
a.
Basis
b.
Credit
c.
Sovereign
d.
None of the above
24. Sovereign risk differs from credit risk because it is dependent on the financial status of the government
rather than the counterparty itself.
a. True
b. False
25. In a period when interest rates are expected to rise, ____ institutions will want a fixed-for-floating
swap, and the fixed rate specified on interest rate swaps will be ____ under these conditions.
a.
many; lower
b.
many; higher
c.
few; lower
d.
few; higher
26. An interest rate swap agreement indicates the ____ value, which represents the principal amount to
which interest rates are applied to determine the interest payments involved.
a.
vanilla
b.
LIBOR
c.
programmed
d.
notional
27. Financial institutions primarily use interest rate swaps in a way that will ____ exposure to interest rate
risk and ____ potential returns.
a.
increase; increase
b.
increase; reduce
c.
reduce; increase
d.
reduce; reduce
28. An advantage of a ____ over other interest rate swaps is that the fixed-rate payer has the flexibility to
avoid exchanging future interest payments.
a.
callable swap
b.
putable swap
c.
zero-coupon for floating swap
d.
forward swap
29. The advantage of a rate-capped interest rate swap to a party exchanging fixed payments for floating
payments (relative to a plain vanilla swap) is that
a.
there is a minimum limit set on interest rate payments received.
b.
there is a maximum limit set on the interest payments it will provide.
c.
it receives an up-front fee.
d.
none of the above
30. The advantage of a rate-capped interest rate swap (relative to a plain vanilla swap) to a party
exchanging floating payments for fixed payments is that
a.
there is a minimum limit set on interest rate payments received.
b.
there is a maximum limit set on the interest payments it will provide.
c.
it receives an up-front fee.
d.
none of the above
31. A plain vanilla swap enables firms to exchange ____ for ____.
a.
fixed rate payments; variable interest rate payments
b.
a high interest rate foreign currency; a low interest rate foreign currency
c.
a low interest rate foreign currency; a high interest rate foreign currency
d.
bonds; stocks that pay dividends
32. An arrangement which enables firms to exchange currencies at periodic intervals is called a
a.
currency swap.
b.
interest rate swap.
c.
swap exchange.
d.
eurobond swap.
33. When a bank participates in a swap of fixed interest rate payments for floating-rate payments, or a
swap of currencies, it
a.
can match up two parties but cannot take a position in the swap.
b.
can match up two parties or can take a position in the swap.
c.
cannot match up two parties and cannot take a position in the swap.
d.
cannot match up two parties but can take a position in the swap.
34. An equity swap involves the exchange of
a.
preferred stock for common stock.
b.
interest payments for an equity position in the counterparty’s firm.
c.
interest payments for payments linked to the degree of change in a stock index.
d.
interest payments for newly issued stock by financial institutions.
35. A firm is involved in an agreement in which it receives payments in periods when a market interest
rate falls below an interest rate level specified in the agreement. This means that the firm has
a.
purchased an interest rate cap.
b.
sold an interest rate cap.
c.
purchased an interest rate floor.
d.
sold an interest rate floor.
36. The typical purchaser of an interest rate cap is a financial institution that is ____ affected by ____
interest rates.
a.
favorably; rising
b.
favorably; falling
c.
adversely; rising
d.
adversely; falling
37. A firm is involved in an agreement in which it makes payments in periods when a market interest rate
rises above an interest rate level specified in the agreement. This means that the firm has
a.
purchased an interest rate cap.
b.
sold an interest rate cap.
c.
purchased an interest rate floor.
d.
sold an interest rate floor.
38. A firm is involved in an agreement in which it makes payments in periods when a market interest rate
falls below an interest rate level specified in the agreement. This means that the firm has
a.
purchased an interest rate cap.
b.
sold an interest rate cap.
c.
purchased an interest rate floor.
d.
sold an interest rate floor.
39. A firm is involved in an agreement in which it receives payments in periods when a market interest
rate rises above an interest rate level specified in the agreement. This means that the firm has
a.
purchased an interest rate cap.
b.
sold an interest rate cap.
c.
purchased an interest rate floor.
d.
sold an interest rate floor.
40. An interest rate collar represents the ____ of an interest rate cap and a simultaneous ____ of an interest
rate floor.
a.
sale; sale
b.
sale; purchase
c.
purchase; purchase
d.
purchase; sale
41. Firms A and B have entered into an interest rate swap. On the first payment date, Firm A owes Firm B
12 percent of $10 million, and Firm B owes Firm A 14 percent of $10 million. Most likely, this
transaction will be settled in what manner?
a.
Firm A will send Firm B $120,000 and Firm B will send Firm A $140,000
b.
Firm B will send Firm A $120,000 and Firm A will send Firm B $140,000
c.
Firm A will send Firm B $20,000
d.
Firm B will send Firm A $20,000
e.
none of the above
42. Financial institutions such as U.S. savings institutions and commercial banks traditionally had fewer
interest rate-sensitive ____ than ____ and therefore were adversely affected by ____ interest rates.
a.
assets; liabilities; increasing
b.
liabilities; assets; decreasing
c.
liabilities; assets; increasing
d.
none of the above
43. The Bank of Moronto has negotiated a plain vanilla swap in which it will exchange fixed payments of
10 percent for floating payments equal to LIBOR plus 0.5 percent at the end of each of the next three
years. In the first year, LIBOR is 8 percent; in the second year, 9 percent; in the third year, LIBOR is 7
percent. What is the total net payment the Bank of Moronto makes over the three-year period if the
notional principal is $10 million?
a.
−600,000
b.
600,000
c.
450,000
d.
−450,000
e.
none of the above
44. Hewitt Inc. has entered into an equity swap arrangement that allows it to swap a fixed interest rate of 8
percent in exchange for the rate of appreciation on the Dow Jones Industrial Average each year over a
three-year period. The notional principal is $1 million. If the Dow depreciates by 1 percent, Hewitt
will
a.
have to make a payment of $70,000.
b.
have to make a payment of $90,000.
c.
receive a payment of $70,000.
d.
receive a payment of $90,000.
e.
none of the above
45. Lizard National Bank purchases a three-year interest rate cap for a fee of 2 percent of notional
principal valued at $50 million, with an interest rate ceiling of 11 percent and LIBOR as the index
representing the market interest rate. Assume that LIBOR is expected to be 9 percent, 12 percent, and
13 percent at the end of each of the next three years, respectively. The total payments received (or
paid) by Lizard, including the initial fee, are $____.
a.
500,000
b.
−500,000
c.
−1,500,000
d.
1,500,000
e.
none of the above
46. Lizard National Bank purchases a three-year interest rate cap for a fee of 2 percent of notional
principal valued at $50 million, with an interest rate ceiling of 11 percent and LIBOR as the index
representing the market interest rate. Assume that LIBOR is expected to be 9 percent, 12 percent, and
13 percent at the end of each of the next three years, respectively. The dollar amount to be received
(or paid) by the seller of the interest rate cap based on the forecast of LIBOR assumed above over the
three-year period is $____.
a.
−500,000
b.
500,000
c.
−1,500,000
d.
1,500,000
e.
none of the above
47. In a ____, a buyer makes periodic payments to a seller in exchange for protection against the possible
default of debt securities specified in the contract.
a.
default option contract
b.
default futures contract
c.
bankruptcy contract
d.
credit default swap
48. A common maturity of a credit default swap contract is:
a.
one month
b.
three months
c.
five years
d.
25 years
49. AIG’s financial problems during the credit crisis were attributed to:
a.
its weak returns on its investments in junk bonds.
b.
its potential losses from its life insurance policies.
c.
fraud from avoiding taxes on its gains from credit default swaps.
d.
its potential losses from credit default swaps.
50. Buyers of credit default swaps are most likely going to receive a payment from the seller of credit
default swaps when the economy:
a.
is very weak.
b.
is stable.
c.
experiences high growth.
d.
experiences low inflation.
51. The primary purpose of interest rate swaps is to reduce exchange rate risk.
a. True
b. False
52. A forward swap allows an institution to lock in the terms of the arrangement today, and the swap
period begins immediately.
a. True
b. False
53. A putable swap gives the party making the fixed-rate payments the right to terminate the swap.
a. True
b. False
54. A rate-capped swap may limit the fixed-rate payer’s ability to effectively hedge against interest rate
risk.
a. True
b. False
55. An equity swap involves the exchange of dividend payments for payments linked to the degree of
change in a stock index.
a. True
b. False
56. There is risk that a firm involved in an interest rate swap may not meet its payment obligations; this
risk is called systemic risk.
a. True
b. False
57. If a large bank that has taken numerous swap positions and guaranteed many other swap positions
fails, there could be several defaults on swap payments.
a. True
b. False
58. The most common proxy for the benchmark rate from which a floating-rate payment is determined is
the prime rate.
a. True
b. False
59. Interest rate swaps are rarely used by companies that issue bonds.
a. True
b. False
60. An interest rate cap offers payments in periods when a specified interest rate index exceeds a specified
floor interest rate.
a. True
b. False
61. Interest rate floors are commonly used to hedge against lower interest rates.
a. True
b. False
62. An interest rate collar involves the purchase of an interest rate cap and the simultaneously sale of an
interest rate floor.
a. True
b. False
63. Which of the following is not a typical provision of an interest rate swap?
a.
the notional principal value to which the interest rates are applied to determine the interest
payments involved
b.
the fixed interest rate
c.
the floating interest rate
d.
the underwriter of the bond
e.
All of the above are provisions of an interest rate swap.
64. A ____ swap involves an exchange of interest rate payments that does not begin until a specified
future point in time.
a.
plain vanilla
b.
zero-coupon-for-floating
c.
forward
d.
seasoned vanilla
e.
putable
65. If a U.S. institution in a forward swap would like to lock in the fixed rate that it will pay when the
swap period begins, it is probably concerned that interest rates will ____; the counterparty is likely
adversely affected by ____ interest rates.
a.
increase; increasing
b.
increase; declining
c.
decrease; declining
d.
decrease; increasing
e.
none of the above
66. A(n) ____ swap provides the party making the floating-rate payments with a right to terminate the
swap.
a.
callable
b.
extendable
c.
plain vanilla
d.
putable
e.
none of the above
67. Interest rate ____ are interest rate derivative instruments that are normally classified separately from
interest rate swaps.
a.
caps
b.
floors
c.
collars
d.
all of the above
68. Which of the following is not a reason for financial institutions to engage in interest rate swaps?
a.
to reduce interest rate risk
b.
to act as an intermediary
c.
to act as a dealer in swaps
d.
all of the above are reasons for financial institutions to engage in swaps
69. A financial institution may participate in the swaps markets by:
a.
serving as an intermediary by matching up parties that wish to engage in a swap.
b.
engaging in swaps to reduce interest rate risk.
c.
assuming the credit risk involved in a swap by guaranteeing that the payments will be
made.
d.
A and B
70. The London Interbank Offer Rate (LIBOR) varies among currencies.
a. True
b. False
71. During the credit crisis, many mortgage-backed securities defaulted, generating large profits for sellers
of credit default swaps and large losses for buyers of the swaps.
a. True
b. False
72. Which of the following is not an advantage of having derivative securities such as swaps traded on an
exchange instead of over the counter?
a.
more transparent pricing
b.
increased trading volume
c.
less standardarized contracts, allowing contracts to be tailored to the parties’ specific
needs
d.
more accurate information about the collateral backing a particular contract
73. The same types of risks that apply to interest rate swaps may also apply to currency swaps, except that
currency swaps are not subject to basis risk.
a. True
b. False