Question 1

Interest rate swaps are rarely used by companies that issue bonds.

Accepted Answer

Interest rate swaps are commonly used by companies that issue bonds to manage their interest rate risk. By entering into an interest rate swap, a company can exchange its variable interest rate payments for fixed interest rate payments, or vice versa, with a counterparty. This can help the company to mitigate the risk of interest rate fluctuations and stabilize its cash flows.

Question 2

An equity swap involves the exchange of dividend payments for payments linked to the degree of change in a stock index.

Accepted Answer

An equity swap typically involves the exchange of future cash flows between two parties, where one set of cash flows is generally based on a fixed interest rate, while the other is based on the return of an equity index, a specific stock, or a basket of stocks. It does not specifically involve the exchange of dividend payments for changes in a stock index, but rather the total return of equities (which can include dividends) for interest payments or the return of another asset.

Question 3

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.

Accepted Answer

If a large bank that has taken numerous swap positions and guaranteed many other swap positions fails, it may not be able to make the required swap payments, leading to defaults on those swaps.

Question 4

____ swap provides the party making the floating-rate payments with a right to terminate the swap.

Accepted Answer

Putable swap provides the party making the floating-rate payments with a right to terminate the swap.

Question 5

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 counterpartyis likely adversely affected by ____ interest rates.

Accepted Answer

The answer of If a U.S. institution in a forward...

Question 6

A ____ swap involves an exchange of interest rate payments that does not begin until a specified future point in time.

Accepted Answer

A forward swap involves an agreement between two parties to exchange a series of interest rate payments at a specified future date. This is different from a plain vanilla swap, which begins right away, and a zero-coupon-for-floating swap, which involves exchanging a fixed payment for a floating payment. There is no such thing as a "seasoned vanilla" or "putable" swap.

Question 7

Which of the following is not a reason why financial institutions engage in interest rate swaps?

Accepted Answer

All of the options listed are reasons why financial institutions engage in interest rate swaps. They use swaps to manage interest rate risk, act as intermediaries to facilitate swaps between other parties, and operate as dealers to provide liquidity in the swap market.

Question 8

The most common proxy for the benchmark rate from which a floating-rate payment is determined is the prime rate.

Accepted Answer

The most common proxy for the benchmark rate from which a floating-rate payment is determined is typically the London Interbank Offered Rate (LIBOR) or, more recently, alternative rates like the Secured Overnight Financing Rate (SOFR) in the United States, rather than the prime rate.

Question 9

An interest rate cap offers payments in periods when a specified interest rate index exceeds a specified floor interest rate.

Accepted Answer

An interest rate cap offers payments in periods when a specified interest rate index exceeds a specified cap interest rate, not a floor. The floor is related to an interest rate floor agreement, which operates oppositely by providing payments when the interest rate falls below a specified level.

Question 10

A forward swap allows an institution to lock in the terms of the arrangement today, and the swap period begins immediately.

Accepted Answer

A forward swap involves an agreement to exchange cash flows at a future date, not immediately. The institution can agree on the terms today, but the swap period doesn't begin until a later date.

Question 11

An interest rate collar involves the purchase of an interest rate cap and the simultaneously sale of an interest rate floor.

Accepted Answer

An interest rate collar involves buying an interest rate cap and selling an interest rate floor at the same time to limit the interest rate risk for the buyer.

Question 12

A putable swap gives the party making the fixed-rate payments the right to terminate the swap.

Accepted Answer

A putable swap actually gives the receiver of the fixed-rate payments the right to terminate the swap.

Question 13

Interest rate floors are commonly used to hedge against lower interest rates.

Accepted Answer

Interest rate floors provide protection to the buyer if interest rates fall below a predetermined floor. Thus, they are commonly used to hedge against lower interest rates.

Question 14

Which of the following is not a typical provision of an interest rate swap?

Accepted Answer

The underwriter of the bond is not a provision of an interest rate swap. The other options (notional principal value, fixed interest rate, and formula/index for floating interest rate) are all typical provisions of an interest rate swap.

Question 15

A rate-capped swap may limit the fixed-rate payer's ability to effectively hedge against interest rate risk.

Accepted Answer

A rate-capped swap sets a limit on the maximum fixed interest rate that the fixed-rate payer will receive, which means that if interest rates rise above the cap, the fixed-rate payer will not receive the full benefit of the hedge. This limits the effectiveness of the hedge and exposes the fixed-rate payer to interest rate risk.

Question 16

A financial institution may participate in the swaps markets by:

Accepted Answer

A financial institution may participate in the swaps markets by both serving as an intermediary by matching up parties that wish to engage in a swap and by engaging in swaps to reduce interest rate risk. By serving as an intermediary, a financial institution can earn fees on the transactions. By engaging in swaps to reduce interest rate risk, a financial institution can manage its exposure to interest rate fluctuations. Option C is not a common way for financial institutions to participate in the swaps markets, as assuming credit risk can be very risky and is usually reserved for specialty firms that specialize in managing credit risk in swaps transactions.

Question 17

Systemic risk is the risk that a firm involved in an interest rate swap may not meet its payment obligations.

Accepted Answer

Systemic risk refers to the risk of collapse of an entire financial system or entire market, due to the failure of a single entity or group of entities, which can lead to a crisis when the failure spreads across the financial system. The risk that a firm involved in an interest rate swap may not meet its payment obligations is known as "credit risk" or "counterparty risk," not systemic risk.

Question 18

Interest rate ____ are interest rate derivative instruments that are normally classified separately from interest rate swaps.

Accepted Answer

Interest rate caps, floors, and collars are all types of interest rate derivative instruments that are distinct from interest rate swaps. They are used to manage interest rate risk by setting limits on interest rate movements.

Question 19

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?

Accepted Answer

The requirement that credit default swaps cannot be created for mortgage-backed securities was actually a restriction put in place by the Dodd-Frank Wall Street Reform and Consumer Protection Act in 2010, before the credit crisis. It is not a new rule issued after the crisis. Therefore, it is not one of the requirements of the new rules and regulations issued post-credit crisis. A, B, and D are all requirements of the new rules and regulations.

Quiz 15: Swap Markets