FMP 20 SWAPS Flashcards
What is a plain vanilla interest rate swap?
An over-the-counter derivative where one party pays fixed interest and receives floating interest on a notional principal.
How are cash flows computed in a plain vanilla interest rate swap?
Cash flows are calculated based on a fixed rate and a floating rate, typically tied to LIBOR.
What is the role of financial intermediaries in the swaps market?
Financial intermediaries facilitate the exchange of cash flows between parties in a swap agreement.
What is the importance of confirmation in a swap transaction?
Confirmation is essential for validating the terms of the swap agreement between parties.
What is the comparative advantage argument for interest rate swaps?
It posits that companies have varying advantages in different debt markets, allowing them to benefit from swaps.
How are discount rates in a plain vanilla interest rate swap computed?
Discount rates are computed using market rates, with OIS replacing LIBOR as the standard post-2008 crisis.
How can you calculate the value of a plain vanilla interest rate swap?
By analyzing two simultaneous bond positions or a sequence of forward rate agreements (FRAs).
What is a currency swap?
A swap agreement where cash flows in one currency are exchanged for cash flows in another currency.
What does a currency swap transform?
It transforms assets or liabilities denominated in one currency into another currency.
What is credit risk exposure in a swap position?
The risk that one party will default on its cash flow obligations in a swap agreement.
List other types of swaps.
- Commodity swaps
- Volatility swaps
- Exotic swaps
When was the over-the-counter swap market born?
The market was initiated with a currency swap between IBM and the World Bank in 1981.
What is the notional principal in a swap?
The amount on which cash flows are calculated but is not exchanged between parties.
What was used as a proxy for the risk-free discount rate before the 2008 crisis?
LIBOR was used prior to the 2008 crisis.
What is the typical payment frequency in a plain vanilla interest rate swap?
Payments are exchanged every six months.
Fill in the blank: A swap can transform a floating-rate loan into a _______.
fixed-rate loan.
Fill in the blank: After entering a swap, Apple’s effective fixed-rate payment becomes _______.
3.1%.
How does a company transform a fixed-rate loan into a floating-rate loan using a swap?
By entering a swap that pays floating and receives fixed.
What interest rate does Intel aim to achieve by entering a swap?
A floating rate linked to LIBOR.
What does the swap agreement between AAA Corp and BBB Corp illustrate?
The comparative advantage in borrowing fixed versus floating rates.
What is the net effect of cash flows for AAA Corp after entering the swap?
It pays less than it would directly in the floating rate market.
True or False: The principal amount in a swap is exchanged between parties.
False.
What happens to the cash flows in a swap from the perspective of the parties involved?
They are netted against each other, resulting in a single cash flow exchanged.
What is the net effect of cash flows for AAA Corp?
AAA Corp pays ___ per annum less than it would pay if it went directly to floating rate markets.
What interest rate does BBB Corp pay to outside lenders?
BBB Corp pays LIBOR + 0.6% per annum.
What does BBB Corp receive from AAA Corp?
BBB Corp receives LIBOR from AAA Corp.
What is the interest rate that BBB Corp pays to AAA Corp?
BBB Corp pays 4.35% per annum to AAA Corp.
What is the total apparent gain from an interest rate swap arrangement?
Total gain is always ∆fixed — ∆floating.
What are the criticisms of the comparative-advantage argument in swaps?
Criticism includes the expectation that spreads should be arbitraged away and that floating rates will not adjust.
What factors contribute to spread differentials between AAA Corp and BBB Corp?
- Credit risk
- Fixed and floating market contract nature
- Rate adjustments based on creditworthiness
What does the Bond Method Valuation for an interest rate swap involve?
The position of one company is equivalent to a long position in floating-rate bond and a short position in a fixed-rate bond.
What is the FRA Method Valuation for an interest rate swap?
Valued by assuming forward rates are realized and discounting swap cash flows at the risk-free rate.
What is a fixed-for-fixed currency swap?
Exchanging principal and interest payments at a fixed rate in one currency for principal and interest payments at a fixed rate in another currency.
In the fixed-for-fixed currency swap example, what fixed rate does British Petroleum pay in dollars?
British Petroleum pays a fixed rate of 3%.
What fixed rate does British Petroleum receive in British pounds?
British Petroleum receives a fixed rate of 4%.
What is the purpose of a currency swap?
To transform borrowings or assets from one currency to another.
What are the two methods to value currency swaps?
- Bond Method
- FRA Method
What does the Bond Method for currency swaps valuation involve?
The value of a swap is the difference between two bonds defined by domestic and foreign cash flows.
What are the two popular types of currency swaps mentioned?
- Fixed-for-floating
- Floating-for-floating
What is credit risk in the context of swaps?
The possibility of a default by the counterparty when the value of the contract is positive.
What is the difference between credit risk and market risk?
Credit risk arises from counterparty default; market risk arises from changes in market variables.
What is credit risk in a financial institution?
The possibility of a default by the counterparty when the value of the contract to the financial institution is positive.
What is market risk in a financial institution?
The possibility that market variables such as interest rates and exchange rates will move in such a way that the value of a contract becomes negative.
How can market risks be hedged?
By entering into offsetting contracts.
Is credit risk easy or difficult to hedge?
Less easy to hedge.
What is the most common reference floating interest rate in fixed-for-floating interest rate swaps?
LIBOR.
What are the standard tenors for LIBOR in interest rate swaps?
One month, three months, and 12 months.
In fixed-for-floating interest rate swaps, does the tenor on the floating side have to match the tenor on the fixed side?
No.
What is a basis swap?
A floating-for-floating interest rate swap.
What is a compounding swap?
A swap where interest on one or both sides is compounded forward to the end of the life of the swap with only one payment date at the end.
What defines a LIBOR-in-arrears swap?
The LIBOR rate observed on a payment date is used to calculate the payment on that date.
What is an accrual swap?
A swap where interest on one side accrues only when the floating reference rate is in a certain range.
What is an amortizing swap?
A swap where the principal reduces in a predetermined way.
What is a step-up swap?
A swap where the principal increases in a predetermined way.
What is a forward swap?
A swap where the parties do not begin to exchange interest payments until a future date.
What is a constant maturity swap (CMS swap)?
An agreement to exchange a LIBOR rate for a swap rate.
What is a constant maturity Treasury swap (CMT swap)?
An agreement to exchange a LIBOR rate for a particular Treasury rate.
What is a Quanto swap?
A swap where a rate observed in one currency is applied to a principal amount in another currency.
What is an equity swap?
An agreement to exchange the total return realized on an equity index for either a fixed or a floating rate of interest.
What is an extendable swap?
A swap where one party has the option to extend the life of the swap beyond the specified period.
What is a puttable swap?
A swap where one party has the option to terminate the swap early.
What are swaptions?
Options on swaps that provide one party with the right to enter into a swap in the future.
What are commodity swaps?
A series of forward contracts on a commodity with different maturity dates and the same delivery prices.
What is a volatility swap?
A swap where one side pays a pre-agreed volatility while the other side pays the historical volatility realized during the period.
What limits the types of swaps that can be created?
The imagination of financial engineers and the desires of corporate treasurers and fund managers.
