Lecture 18

Question 1

Swaps =

Answer 1

Multi-period extensions of forward contracts

Question 2

Interest rate swap =

Answer 2

Exchanging cash flows based on a fixed rate for cash flows based on a floating rate

Question 3

Foreign exchange swap =

Answer 3

Exchange of currencies on several future dates

Question 4

When two swaps are combined

Answer 4

Deal’s position is effectively neutral

Question 5

At the time the transaction is initiated

Answer 5

It has a 0 NPV, to both parties. It is simply a contract to exchange cash in the future

Question 6

Even if one party backs out

Answer 6

No cost to counterparty > simply find replacement

Question 7

If interest rates increase shortly after interest rate swap

Answer 7

• Floating rate payer suffers loss

- Fixed rate payer enjoys gain

Question 8

Loss =

Answer 8

Difference between values of fixed and floating rate obligations, not the total value of payments payer obligated to make

Question 9

Credit default swaps

Answer 9

Designed to allow lenders to buy protection against default risk and enhance creditworthiness of outstanding loans

Question 10

Credit default swaps logistics

Answer 10

Seller collects the annual payments for the term contract, but must compensate the buyer for the loss in bond value in the event of a default

Question 11

CDS issuer

Answer 11

Agrees to buy the bond in default/ pay difference between par and market values to CDS buyer

Question 12

Swap holder does not need to

Answer 12

Hold bonds in underlying CDS contract

Question 13

Can there be more contracts outstanding than physical bonds to insure?

Answer 13

Yes > Lehman Brothers