Exam: CH 7 Swaps Flashcards
What is a swap?
- A swap is an agreement between two companies to exchange cash flows in the future
What does the agreement in a swap include?
- includes the dates when the cash flows are paid and the way in which they are
calculated
What is the most common swap and explain what it is?
- plain vanilla swap
- One company agrees to pay cash flows equal to
interest at a predetermined fixed rate on a notional principal for a number of years. - In return, the other company pays interest at a floating rate on the same notional principal for
the same period of time
What is the most common floating rate?
- LIBOR. Typically 1-month, 3-month, 6-month, and 12-month rates
Microsoft can use the swap to transform a _____-___ loan into a _____-___ loan
- Floating-rate
- Fixed-rate
The swap can change an asset earning a ____ ____ of income into an asset that earns a ____ ____ of interest.
- Fixed rate
- Floating rate
How are swaps arranged?
- Companies usually do not get in touch with each other to arrange swaps.
- Rather companies deal through a financial intermediary
What is a basis point?
- a unit of measure used in finance to describe the percentage change in the value or rate of a financial instrument
- One basis point is equivalent to 0.01%
Who acts as market makers for swaps and why?
- Many large financial institutions act as market makers for swaps, since unlikely that two companies
have completely compatible needs
The swap rate is the average of?
- the fixed rate that a swap market maker is prepared to pay in exchange for receiving LIBOR (bid)
- the fixed rate that it is prepared to receive in return for paying LIBOR (offer)
Is the principle exchanged in swap agreements?
- No
In valuing swaps helpful to think of the principal as being exchanged. Then from the perspective of
the _____-____ _____, a swap can be regarded as a _____ _____ in fixed rate bond and _____ _____ in floating rate bond.
- Floating-rate payer
- Long position
- Short position
From the perspective of the _____-_____ _____, a swap can be regarded as a _____ _____ in fixed
rate bond and _____ _____ in floating rate bond
- Fixed-rate payer
- Short position
- Long position
What is a currency swap?
- A currency swap is an agreement to exchange principal and interest payments in
one currency for principal and interest payments in another
In a currency swap when are the principal amounts usually exchanged?
- Principal amounts (usually approximately equivalent) are usually exchanged at
the beginning and at the end of the swap
Are swap contracts sold on an exchange or OTC?
- OTC
- they are private arrangements between two
companies
- they are private arrangements between two
What happens to the financial intermediary if both parties don’t default on the swap?
- the financial intermediary remains fully hedged
(risk-free), since a decline in the value of one position is offset by the increase
in the in the value of the opposite position
What is credit risk?
- Its the possibility of a default by the counterparty
What is a amortizing swap?
- a swap in which the principal decreases in a predetermined way. (The value
decreases in time, i.e. loans or cars)
What is a step up swap?
- principal increases in a predetermined way. i.e. drawdowns on a loan
agreements.
What is a forward swap?
- parties do not exchange interest rate payments until some future date (also
called deferred swap)
What is a constant maturity swap?
- agreement to exchange a LIBOR rate for a swap rate. i.e. 6-month
LIBOR applied to a certain principal for the 10-year swap rate applied to the same principal
every 6 months for the next 5 years.
What is a constant maturity treasury swap?
similar. exchange LIBOR for particular Treasury rate
What is a compounding swap?
- interest on one or both sides is compounded forward to the end of the
life of the swap according to preagreed rules. Only one payment date at the end of the life of the swap
