Risk Management Applications of Swap Strategies
Test ID: 7428319
Question #1 of 42
Question ID: 466599
A firm has outstanding floating rate debt on which they pay LIBOR + 200 basis points, and management expects interest rates
to increase in the very near future. In order to create synthetic fixedrate debt, the best strategy for the firm is to enter into a
swap in which they:
✗ A) pay floating and receive fixed.
✗ B) receive floating and pay floating.
✓ C) pay fixed and receive floating.
To create synthetic fixedrate debt, the firm should pay fixed and receive floating in a swap. The floating rate payment they
receive in the swap will partially offset the floating rate they pay on their debt. Any portion of the floating rate on the debt that
remains (assume 100bps) will add to the fixed rate they pay on the swap. Their net position on the debt and the swap will be
pay fixed + 100 bps = fixed rate.
Question #2 of 42
Question ID: 466610
An investor has a $5,000,000 investment in smallcap stocks. The investor enters into an equity index swap where the investor
pays the return on the Russell 2000 and receives the return on the Dow Jones Industrial Average. The notional principal of the
swap is $1 million. The resulting position is a synthetic mix of:
✗ A) 16.67% large stocks and 83.33% small stocks.
✓ B) 20% large stocks and 80% small stocks.
✗ C) 25% large stocks and 75% small stocks.
After the swap, $1 million, or 20% of the portfolio's exposure will be invested in the Dow Jones Industrial Average index of
large stocks. $4 million, or 80% of the portfolio will remain invested in small stocks. The $1 million notional principal represents
20% of the position. That is the amount that has been synthetically transferred from one class of assets to the other.
Question #3 of 42
Question ID: 466597
A payfloating counterparty in a plainvanilla interestrate swap also holds a long position in a fixedrate bond. If the maturity of
the bond and swap are both two years, the duration of the position will be:
✓ A) greater than the duration of the bond alone.
✗ B) zero.
✗ C) less than the duration of the bond but greater than zero.
The duration of the position will increase with the addition of the payfloating/receivefixed position. Both of the remaining
answers cannot be correct.
Questions #49 of 42
Jane Hiatt and Penny Hoskins have responsibility for interest rate and currency risk management for the Rensselaer
Corporation, a large multinational firm based in the Midwestern United States.
Due to an increase in global economic growth, Rensselaer has seen its sales increase and is planning to expand its U.S.
factory at a cost of $30,000,000. The factory expansion will be financed at a floating interest rate of LIBOR plus 200 basis
points, with payments made quarterly over seven years. Hiatt expects that Rensselaer will begin the expansion in six months
and will receive the $30,000,000 in financing at that point in time. She is concerned, however, that global interest rates will
increase in the interim and would like to have the option to convert the loan's interest rate to a fixed rate in six months. Hiatt
evaluates the forecasts for future swap fixed rates as well as the current terms of various swaptions, provided in the following
table. The swaptions are for a 7year swap where the floating interest rate is LIBOR flat.
Fixed rate for payer's swaption that matures in six months
Fixed rate for receiver's swaption that loater which is an outstanding bond liability in which they will have to pay 1.2 x
LIBOR x value of the floater. To hedge the risk of interest rates increasing they have entered into a swap as the fixed rate
payer and floating rate receiver using the LIBOR payments received in the swap to pay on the leveraged floater. Since the
payment on the leveraged floater is 1.2 x LIBOR, the notional principal of the swap and the bond purchased would have to be
1.2 x value of the leveraged floater issued or 1.2 x 12,000,000. They are earning a positive spread on the swap by purchasing
a bond that pays 6% in which they use that payment to pay the 4.4% fixed in the swap. The following is not required by the
LOS but is for understanding purposes only. The net cash flow to JMI is:
Net cash flow = multiplier × VFloater × (CBond Swap Fixed Rate)
Net cash flow = 1.2 × 12,000,000 × [(0.06 / 2) − (0.044 / 2)] = $115,200
(Study Session 15, LOS 31.d)
Question #32 of 42
Question ID: 466600
For an issuer of a floatingrate note, the market value of the loan will be:
✓ A) relatively stable but the position will become less stable with the addition of a receive
floating swap position.
✗ B) volatile, but the position will become more stable with the addition of a receivefloating
✗ C) zero with the addition of a payfloating swap position.
A floatingrate note's value will be relatively stable because the payments vary with changes in the interest rates. Adding a
receivefloating position will produce a synthetic fixedpayment position whose value will change with changes in interest rates.
Question #33 of 42
Question ID: 466611
A manager of a $300 million bond portfolio consisting of $50 million in investmentgrade corporate bonds and $250 million in
U.S. Treasuries wants to reweight to a 50/50 mix. This can be done with a bondindex swap with a notional principal of:
✗ A) $250 million.
✓ B) $100 million.
✗ C) $275 million.
The swap would exchange the return on $100 million in U.S. Treasuries for the return on $100 million of the corporate bonds.
This would create a synthetic mix of $150 million in each position.
Question #34 of 42
Question ID: 466609
A U.S. firm that wishes to convert its annual cash flows of €10 million each to US$ upon receipt. The exchange rate is currently
0.9€/$, and the swap rates in the U.S. and Europe are 5.4% and 5% respectively. Appropriately using a fixedforfixed
currency swap that does not exchange principal, what would be the annual dollar cash flow to the firm?
✓ A) $12,000,000.
✗ B) $11,111,111.
✗ C) $22,222,222.
At current interest rates, the €10 million per year translates to a notional principal of:
NP = 10,000,000 / 0.05
NP = €200,000,000
The corresponding dollar amount is $222,222,222 = €200,000,000 / (0.9€/$). The annual interest payments on this amount
would be $12,000,000 = $222,222,222 × 0.054.
Question #35 of 42
Question ID: 466573
A bank that has made a $6 million floating rate loan at LIBOR plus 240 basis points wishes to convert it to a fixedrate loan.
The bank uses a swap with a fixed rate equal to 6.4%, floating rate equal to LIBOR, and notional principal equal to $6 million. If
the payments are quarterly, which of the following most closely approximates the quarterly inflows to the bank from the loan
and the swap?
✗ A) $88,000.
✗ B) $60,000.
✓ C) $132,000.
The bank will enter into the swap to pay LIBOR and receive 6.4%. It passes the LIBOR from the borrower through and keeps
the 240 basis points. Thus, the firm earns (0.064 + 0.024) / 4 on $6 million each quarter. This is $132,000.
Question #36 of 42
Question ID: 466608
A U.S. firm that wishes to convert its quarterly cash flows of
7 million each to dollars upon receipt. The exchange rate is
0.8/US$, and the swap rates in the U.S. and Europe are 5.2 percent and 5.6 percent respectively. What should be
the notional principal in dollars of a currency swap, where the principal is not exchanged and the rates are fixed, that will
accomplish the goal?
✗ A) $500,000,000.
✗ B) $8,125,000.
✓ C) $625,000,000.
At current interest rates, the
7 million per quarter translates to a notional principal in the foreign currency of:
NP = 7,000,000 / (0.056 /4)
The notional principal in U.S. dollar terms is:
500,000,000 X US$/
0.8 = $625,000,000
The quarterly cash flows on the swap would then be $625,000,000 X 0.52/4 = $8,125,000
Question #37 of 42
Question ID: 466607
A U.S. firm that wishes to convert its annual cash flows of €20 million each to dollars upon receipt. The exchange rate is
currently €0.9/USD, and the swap rates in the U.S. and Europe are both 6.1 percent. Appropriately using a fixedforfixed
currency swap that does not exchange principal, what would be the annual dollar cash flow to the firm?
✗ A) $10,980,000.
✓ B) $22,222,222.
✗ C) $32,786,885.
At current interest rates, the €20 million per year translates to a notional principal of:
NP = 20,000,000 / 0.061
NP = €327,868,852
The corresponding dollar amount is $364,298,725 = €327,868,852 / (€0.9/$). The annual interest payments on this amount
would be $22,222,222 = $364,298,725 × 0.061.
Question #38 of 42
Question ID: 466575
Which of the following statements about debt is least accurate?
✓ A) To create synthetic dual currency debt, the portfolio manager can issue domestic debt
and enter into a fixedforfixed currency swap where notional principal is swapped at
✗ B) To create synthetic callable debt from existing noncallable debt, the portfolio manager
can enter into a receiver's swaption.
✗ C) The allincost is another way of saying "the internal rate of return of a financing
To create synthetic dual currency debt, the portfolio manager can issue domestic debt and enter into a fixedforfixed currency
swap where notional principal is NOT swapped at origination.
Question #39 of 42
Question ID: 466613
A firm has most of its liabilities in the form of floatingrate notes with a maturity of two years and a quarterly reset. The firm is
not concerned with interest rate movements over the next four quarters but is concerned with potential movements after that.
Which of the following strategies will allow the firm to hedge the expected change in interest rates?
✗ A) Enter into a 2year, quarterly payfixed, receivefloating swap.
✓ B) Go long a payer's swaption with a 1year maturity.
✗ C) Go short a payer's swaption with a 2year maturity.
The firm will want to receive floating payments to offset the volatility of its floatingrate obligations. A payer's swaption allows
the firm to become a fixedrate payer/floatingrate receiver in a swap. The oneyear maturity corresponds to the start of the
period of concern.
Question #40 of 42
Question ID: 466592
For a plainvanilla interestrate swap with annual reset, which of the following is closest to the duration for the floating side of
✓ A) 0.50.
✗ B) 0.75.
✗ C) 1.00.
The duration of the floating side is 1/2 the time until the next reset date. Since this is an annual pay swap the duration of the
floating side is 1 x .5 = .5 or 1 divided by 2 = .5. The duration of the fixed side of a swap is approximately .75 to the time until
maturity. If we take a different example of a 4 year swap with semiannual payments the duration of the fixed side would be
.75 x 4 = 3 and the duration of the floating side is .5 / 2 = .25.
Question #41 of 42
Question ID: 466614
A borrower who is also the owner of a swaption that gives the holder the right to become a fixedrate payer and floatingrate
receiver would most likely do which of the following? Exercise the swaption when interest rates:
✗ A) decrease to convert a floatingrate loan to a fixedrate loan.
✓ B) increase to convert a floatingrate loan to a fixedrate loan.
✗ C) increase to convert a fixedrate loan to a floatingrate loan.
The owner will benefit when interest rates increase because the owner has the right to pay a fixed rate and receive the floating
rate, which will be higher with the increase in interest rates. Receiving the floating rate and paying the fixed rate can turn a
floatingrate loan to a fixedrate loan.
Question #42 of 42
Question ID: 466596
Which of the following statements regarding a firm that currently has fixedrate, noncallable domestic debt outstanding is least
accurate? The firm:
✓ A) is exposed to an increase in interest rates.
✗ B) can turn the debt into callable debt by entering into a receiver's swaption position.
✗ C) can turn the debt into floating rate by entering a receivefixed swap position.
The firm isn't concerned with rising rates. If rates fall, however, they face an increase in the value of their liabilities or market
value risk (which is a type of interest rate risk).