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CFA Program Level 1 | Derivative InvestmentsPages
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2023
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CFA Level 1 - Derivative Investments Session 17 - Reading 64 (Notes, Practice Questions, Sample Questions) 1. Which of the following is NOT considered a reason for using the swaps market? To: A)reduce transactions costs. B)exploit market ine ciencies. C)maintain privacy. Explanation: (B) Historically, the two basic motivations for swaps were to exploit market ine ciencies and attempt to achieve cheaper ﬁnancing. Today,the swaps market has matured and now o ers few arbitrage opportunities toexploit market ine ciencies. In addition to seeking cheaper ﬁnancing, currentreasons for using swaps include reducing transactions costs, avoiding costlyregulations, and maintaining privacy. 2. Which of the following statements about notional principal in plain vanilla interest rate swaps is least accurate? Notional principal: A)is not exchanged by the counterparties. B)is used to calculate the ﬁxed rate interest payment; the swap's marketvalue is used to calculate the ﬂoating rate payment. C)does not vary during the swap tenor Explanation: (B) The notional amount is used to calculate both the ﬁxed and the ﬂoating rate payment streams. Both of the other choices are true 3. Which of the following statements about a currency swap is least accurate? A)The periodic interest payments are exchanged in full each period. B)Most currency swaps are done to exploit market ine ciencies. C)Notional principal is exchanged at the termination of the swap Explanation: (B) Unlike interest rate swaps, notional principal is swapped at both the initiation and the termination of the swap. Full interest payments areexchanged at each settlement date. Exploiting market ine ciencies was oncea motivation for currency swaps, but it is not today (because the market is
e cient). Today motivations range from reducing transactions costs tomaintaining privacy to avoiding regulation 4. Which transaction would least likely be classiﬁed as an interest rate swap? A)Receive AUD ﬁxed, pay NZD ﬂoating. B)Receive U.S. ﬁxed, pay U.S. commercial paper.C)Pay USD ﬁxed, receive U.S. LIBOR Explanation: (A) Because it involves two di erent currencies, this would be a currency swap 5. Which of the following statements involving a plain vanilla interest rate swap is least accurate? In a plain interest rate swap, the: A)counterparty who receives the ﬁxed payment by agreeing to pay variablerate interest is called the receive-ﬁxed side of the swap. B)parties generally agree to swap the notional principal. C)parties involved in the swap agreement are called counterparties Explanation: (B) The notional principal is the dollar amount speciﬁed in the swap agreement. The counterparties use the notional principal to determinethe amount of the interest payments. They generally do not exchange thenotional principal 6. Which of the following statements about swaps is least accurate? A)The notional principal is swapped at the beginning and end of a currencyswap.B)Motivations to engage in swaps include reducing transaction costs andmaintaining privacy. C)The notional principal is swapped at the beginning of an interest rateswap Explanation: (C) In interest rate swaps, there is no need to actually exchange the notional amount, since the notional principal swapped is the same for bothcounterparties and in the same currency units. Net interest is paid by the onewho owes it at settlement dates.Explanations for other responses:The reasons given now for using the swap markets are to: reduce transactionscosts, avoid costly regulations, and maintain privacy. Historically, there weretwo basic motivations for swaps: to exploit perceived market ine ciencies andto attempt to obtain cheaper ﬁnancing. Both of these motivations are basedon the concept that the ﬁnancial markets are ine cient. This fact,
unfortunately, is no longer true. Today, the swap markets are mature ando er few arbitrage opportunities. Swap markets are now viewed as beingmore operationally e cient and a more ﬂexible means of packaging andtransforming cash ﬂows than any other method. Currency swaps often occurbecause of comparative advantage. For example, parties may want to reduceborrowing costs. One ﬁrm may have better access to a country’s domesticcapital markets than another ﬁrm. The U.S. ﬁrm (D) may have access to theU.S. capital markets but not the German markets, while the German ﬁrm (M)may have access to the German markets but not the U.S. markets. If each ﬁrmborrows locally and then exchanges the funds, they will both gain.In a currency swap, interest payments are made without netting. Full interestpayments are exchanged at each settlement date. Currency swapcounterparties actually exchange notional principal because the motivation ofthe parties is to receive foreign currency 7. Consider a $10,000,000 1-year quarterly-pay swap with a ﬁxed rate of 4.5% and a ﬂoating rate of 90-day London Interbank O ered Rate (LIBOR)plus 150 basis points. 90-day LIBOR is currently 3% and the current forwardrates for the next four quarters are 3.2%, 3.6%, 3.8%, and 4%. If these ratesare actually realized, at the termination of the swap the ﬂoating-rate payerwill: A)pay $25,000. B)pay $20,000. C)pay $10,020,000 Explanation: (B) The payment at the fourth (ﬁnal) settlement date will be based on the realized LIBOR at the third quarter, 3.8%. The net payment bythe ﬂoating rate payer will be:(0.038 + 0.015 − 0.045) × 90/360 × 10,000,000 = $20,000 8. 123, Inc. has entered into a "plain-vanilla" interest rate swap on $10,000,000 notional principal. 123 company receives a ﬁxed rate of 6.5% onpayments that occur at monthly intervals. Platteville Investments, a swapbroker, negotiates with another ﬁrm, PPS, to take the pay-ﬁxed side of theswap. The ﬂoating rate payment is based on LIBOR (currently at 4.8%). At thetime of the next payment (due in exactly one month),123, Inc. will: A)receive net payments of $42,500. B)receive net payments of $14,167. C)pay the dealer net payments of $14,167 Explanation: (B) The net payment formula for the ﬂoating rate payer is: Floating Rate Paymentt = (LIBORt-1 − Swap Fixed Rate) × (# days in term /360) × Notional Principal
If the result is positive, the ﬂoating-rate payer owes a net payment and if theresult is negative, then the ﬂoating-rate payer receives a net inﬂow. Note: Weare assuming a 360 day year.Floating Rate Payment = (0.048 − 0.065) × (30 / 360) × 10,000,000 =-$14,167.Since the result is negative,123 Inc. will receive this amount 9. XYZ company has entered into a "plain-vanilla" interest rate swap on $1,000,000 notional principal. XYZ company pays a ﬁxed rate of 8% onpayments that occur at 90-day intervals. Six payments remain with the nextone due in exactly 90 days. On the other side of the swap, XYZ companyreceives payments based on the LIBOR rate. Describe the transaction thatoccurs between XYZ company and the dealer at the end of the ﬁrst period ifthe appropriate LIBOR rate is 8.8%. A)Dealer receives $2,000.B)Dealer pays XYZ company $20,000. C)XYZ company receives $2,000 Explanation: (C) XYZ company owes the dealer ($1,000,000)(0.08)(90/360) = $20,000. The dealer owes XYZ company ($1,000,000)(0.088)(90/360) =$22,000. Net: The dealer pays XYZ company $22,000 - $20,000 = $2,000 10. Which of the following statements about swaps is NOT correct? A)In an interest rate swap, only the net interest payments are made. B)In a currency swap, only net interest payments are made. C)In an interest rate swap, the pay-ﬁxed party makes a sequence of ﬁxed rateinterest payments and receives a sequence of ﬂoating rate interest payments Explanation: (B) In a currency swap, the two parties exchange cash at the initiation, make periodic interest payments to each other during the life of theswap agreement, and exchange the principal at the termination of the swap 11. Which term does NOT apply to interest rate swaps? A)Time to maturity.B)Notional principal amount. C)Trading exchange Explanation: (C) Interest rate swaps are currently not traded on exchanges Which of the following statements regarding a plain vanilla swap is NOTcorrect?
A)The notional principal amounts are exchanged at contract initiationand at the termination of the swap. B)Only a net payment is made on each settlement date.C)If interest rates decrease, the swap has a negative value to the ﬁxed ratepayer Explanation: (A) There is no exchange of the principal amount at the initiation or termination of a plain vanilla swap 12. Consider a currency swap in which Party A pays 180-day London Interbank O ered Rate on $1,000,000 and Party B pays the Japanese yen riskless rateon 130,000,000 yen. Which of the following statements regarding the termsrequired at the initiation of the swap is CORRECT? A)Party A must pay 130,000,000 yen and receive $1,000,000. B)An exchange of principal amounts is not required at the initiation of theswap.C)Party A must pay $1,000,000 and receive 130,000,000 yen Explanation: (A) Since Party A is paying in dollars, Party A must receive dollars in exchange for yen at the beginning of the swap 13. Consider a quarterly-pay currency swap where Party A pays London Interbank O ered Rate (LIBOR) on $1,000,000 and Party B pays 4% on900,000 euros. Current LIBOR is 3% and at the end of 90 days it is 4%. Whichof the following statements regarding the ﬁrst settlement date is mostaccurate? A)Party A must make a payment of $7,500. B)Party A must make a payment of $10,000.C)The payments made depend on the exchange rate Explanation: (A) Floating rate payments in a swap are based on the reference rate for the prior period. The payment is:0.03 × 90/360 × 1,000,000 = $7,500 14. A swap in which one party pays a ﬁxed rate, one party pays a ﬂoating rate, and only a net payment is made on the settlement dates is referred to asa: A)plain vanilla swap. B)straight swap.C)net swap
Explanation: (A) A swap in which one party pays a ﬁxed rate, one party pays a ﬂoating rate, and only a net payment is made on the settlement dates isreferred to as a plain vanilla swap 15. HobbyHorse Syndicate has entered into a "plain-vanilla" interest rate swap on $100,000,000 notional principal. HobbyHorse receives a ﬁxed rate of 7.5%on payments that occur every six months. The ﬂoating rate payment is basedon LIBOR (currently at 6.75%). Because of the volatile interest rateenvironment, HobbyHorse has created a reserve to cover any cash outlayrequired at settlement dates. At the time of the next payment (due in exactlysix months), the reserve balance is $250,000. To fulﬁll its obligations underthe swap at the next payment date, HobbyHorse will need approximately howmuch additional cash? A)$0. B)$375,000.C)$125,000 Explanation: (A) The net payment formula for the ﬂoating rate payer is: Floating Rate Paymentt = (LIBORt-1 - Swap Fixed Rate) × (# days in term /360) × Notional PrincipalIf the result is positive, the ﬂoating-rate payer owes a net payment and if theresult is negative, then the ﬂoating-rate payer receives a net inﬂow. Note: Weare assuming a 360 day year.Here, ﬂoating rate payment = (0.0675 - 0.075) × (180 / 360) × 100,000,000= -$375,000. Since the result is negative, HobbyHorse will receive thisamount. Thus, HobbyHorse needs $0 additional cash 16. Why are payments NOT usually netted out in a currency swap? A)There are no payments in a currency swap except at initiation and maturity.B)There is no credit risk in a currency swap. C)The payments are denominated in two di erent currencies Explanation: (C) Payments are not usually netted out because the payments are denominated in two di erent currencies, which does not easily allow fornetting 17. The term exchange of borrowings refers to: A)currency swaps. B)swaptions.C)interest rate swaps
Explanation: (A) In e ect, in a currency swap, the two parties make independent borrowings and then exchange the proceeds. This is known as anexchange of borrowings. A swaption is an option on a swap that can be eitherAmerican or European in form 18. In a plain vanilla interest rate swap: A)payments equal to the notional principal amount are exchanged at theinitiation of the swap.B)each party pays a ﬁxed rate of interest on a notional amount. C)one party pays a ﬂoating rate and the other pays a ﬁxed rate, bothbased on the notional amount. Explanation: (C) A plain vanilla swap is a ﬁxed-for-ﬂoating swap 19. No Errors Printing has entered into a "plain-vanilla" interest rate swap on $1,000,000 notional principal. No Errors receives a ﬁxed rate of 5.5% onpayments that occur at quarterly intervals. Platteville Investments, a swapbroker, negotiates with another ﬁrm, Perfect Bid, to take the pay-ﬁxed side ofthe swap. The ﬂoating rate payment is based on LIBOR (currently at 6.0%).Because of the current interest rate environment, No Errors expects to pay anet amount at the next settlement date and has created a reserve to cover thecash outlay. At the time of the next payment (due in exactly one quarter), thereserve balance is $1,000. To fulﬁll its obligations under the swap, No Errorswill need approximately how much additional cash? A)No Errors will receive $250. B)$250. C)$0. Explanation: (B) The net payment formula for the ﬂoating rate payer is: Floating Rate Paymentt = (LIBORt-1 − Swap Fixed Rate) × (# days in term /360) × Notional PrincipalIf the result is positive, the ﬂoating-rate payer owes a net payment and if theresult is negative, then the ﬂoating-rate payer receives a net inﬂow. Note: Weare assuming a 360 day year.Here, Floating Rate Payment = (0.06 − 0.055) × (90 / 360) × 1,000,000 =$1,250. Since the result is positive, No Errors will pay this amount. Since thereserve balance is $1,000, No Errors needs an additional $250 20. Consider a $10,000,000 1-year quarterly-pay swap with a ﬁxed rate of 4.5 percent and a ﬂoating rate of 90-day London Interbank O ered Rate(LIBOR) plus 150 basis points. 90-day LIBOR is currently 3 percent and thecurrent forward rates for the next four quarters are 3.2 percent, 3.6 percent,
3.8 percent, and 4 percent. If these rates are actually realized, at the ﬁrstquarterly settlement date: A)the ﬁxed-rate payer will be required to make a payment of $7,500.B)the ﬂoating rate payer will be required to make a payment of $92,500. C)no payments will be made. Explanation: (C) The ﬁrst ﬂoating rate payment is based on current LIBOR + 1.5% = 4.5%. This is equal to the ﬁxed rate so no (net) payment will be madeon the ﬁrst settlement date 21. Currency swap markets consist of transactions in: A)the forward market only.B)spot markets only. C)both spot and forward contracts Explanation: (C) In this explanation, Euro is used to represent foreign currency. In a currency swap, one counterparty (D) holds dollars and wantsEuros. The other counterparty (E) holds Euros and wants dollars. They decideto swap their currency positions at the current spot exchange rate. Thecounterparties exchange the full notional principal at the onset of the swap.Then, on each settlement date, one party pays a ﬁxed rate of interest on theforeign currency received, and the other party pays a ﬂoating rate on thedollars received. Interest payments are not netted. Generally, the variableinterest rate on the dollar borrowings is determined at the beginning of thesettlement period and paid at the end of the settlement period. At theconclusion of the swap, the notional currencies are again exchanged. Thus,currency swaps involved transactions in both the spot and forward (future)markets. A ﬁxed-for-ﬁxed currency swap is equivalent to a portfolio of foreignexchange forward contracts (both parties need to deliver currency in thefuture)
CFA Level 1 - Derivative Investments Session 17 - Reading 64
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