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Indicate whether the statement is true or false.
1. The primary purpose of interest rate swaps is to reduce exchange rate risk.
a. True
b. False
2. 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
3. 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
4. An interest rate cap offers payments in periods when a specified interest rate index exceeds a specified floor interest
rate.
a. True
b. False
5. Interest rate floors are commonly used to hedge against lower interest rates.
a. True
b. False
6. The London Interbank Offer Rate (LIBOR) varies among currencies.
a. True
b. False
7. A putable swap gives the party making the fixed-rate payments the right to terminate the swap.
a. True
b. False
8. 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
9. 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
10. An equity swap involves the exchange of interest payments for payments linked to the degree of change in a bond
index.
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b. False
11. 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
12. Systemic risk is the risk that a firm involved in an interest rate swap may not meet its payment obligations.
a. True
b. False
13. 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
14. A rate-capped swap may limit the fixed-rate payer’s ability to effectively hedge against interest rate risk.
a. True
b. False
15. Interest rate swaps are rarely used by companies that issue bonds.
a. True
b. False
16. 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
17. The most common proxy for the benchmark rate from which a floating-rate payment is determined is the prime rate.
a. True
b. False
Indicate the answer choice that best completes the statement or answers the question.
18. 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
19. 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. LIBOR is
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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 these are correct.
20. An arrangement that enables firms to exchange currencies at periodic intervals is called a(n)
a. currency swap.
b. interest rate swap.
c. swap exchange.
d. Eurobond swap.
21. 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
22. 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 these are correct.
23. 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.
24. Which of the following is a reason why financial institutions 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 these are reasons why financial institutions engage in swaps.
25. A firm is involved in an agreement whereby 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.
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26. 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. serving as an intermediary by matching up parties that wish to engage in a swap AND engaging in swaps to
reduce interest rate risk.
27. 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 these are correct.
28. The advantage of a rate-capped interest rate swap (relative to a plain vanilla swap) to the party exchanging fixed
payments for floating payments is that
a. there is a minimum limit set on the 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 these are correct.
29. ____ risk prevents an interest rate swap from completely eliminating a financial institution’s exposure to interest rate
risk.
a. Credit
b. Basis
c. Sovereign
d. None of these are correct.
30. 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
31. 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 these are correct.
32. If a firm negotiates a plain vanilla swap, it will provide ____ payments in exchange for ____ payments.
a. fixed-rate; floating-rate
b. fixed-rate euro; fixed-rate dollar
c. stock dividend; fixed-rate
d. stock dividend; floating-rate
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33. In a swap arrangement, the most common index used for floating-rate payments is 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.
34. 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 formula and type of index used to determine the floating interest rate
d. the underwriter of the bond
e. All of these are provisions of an interest rate swap.
35. 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 these are correct.
36. 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
37. 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
38. 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
39. 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.
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d. municipal governments.
40. The Bank of Moronto has negotiated a plain vanilla swap whereby 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 these are correct.
41. 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 these are correct.
42. 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
43. A(n) ____ swap allows the party making fixed payments to extend the swap period.
a. forward
b. extendable
c. callable
d. putable
44. 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 rates will move in an unfavorable direction do not hedge
their positions.
45. 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 over the year, 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.
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e. None of these are correct.
46. A firm is involved in an agreement whereby 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.
47. 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.
48. ____ 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 these are correct.
49. 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
50. 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.
51. 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
52. 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 these are correct.
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53. 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 these are correct.
54. 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
55. If a financial institution that has more rate-sensitive liabilities than assets 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
56. 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.
57. A firm is involved in an agreement whereby 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.
58. A plain vanilla swap enables firms to exchange ____ for ____.
a. fixed-rate payments; floating-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
59. An interest rate collar involves the ____ of an interest rate cap and the simultaneous ____ of an interest rate floor.
a. sale; sale
b. sale; purchase
c. purchase; purchase
d. purchase; sale
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60. 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 these are correct.
61. AIG’s financial problems during the credit crisis were attributed to
a. its purchases of credit default swaps.
b. its position as a counterparty in numerous interest rate swaps.
c. its sales of mortgage-backed securities.
d. its sales of credit default swaps.
62. A common maturity of a credit default swap contract is
a. one month.
b. three months.
c. five years.
d. 25 years.
63. After the credit crisis, new rules and regulations were issued to reform the swap markets. Which of the following is
NOT one of the requirements of these new rules and regulations?
a. Dealers and major participants in swaps must register with the Commodities Futures Trading Commission or the
Securities and Exchange Commission.
b. To make the market more transparent, the majority of swaps are to be traded on electronic platforms called swap
execution facilities.
c. Credit default swaps can no longer be created for mortgage-backed securities.
d. Information about all swaps must be reported to a swap data repository.
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Answer Key
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