MaxMarkCh20QuestionsOnly.docx
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MaxMarkCh20QuestionsOnly
MaxMark—Viney
MenuItem20:
(Topic20)Interestrateswaps,currencyswapsandcreditdefaultswaps
Question1:
ThetreasurerofMultinationalLimitedhasbeenaskedbytheboardofdirectorstoconductareviewofitsexistingfundingstrategiesandfinancialriskmanagementtechniques.Withinthereview,thetreasurerwillreportontheadvantagesoftheinterestrateandcurrencyswaptransactionsthatarecurrentlyusedbythecompany.Whichofthefollowingisgenerallynotanadvantageoftheseswaptransactions?
A:
allowingthecompanytoachievealowercostoffunds
B:
hedgingofbothinterestrateriskandforeignexchangerisk
C:
facilitatingtherestructureofcashflowsassociatedwithexistingborrowings
D:
transferringthecounterpartyexposureoftheoriginalfundingarrangement
Feedback:
Aswapinvolvestwopartiesagreeingtoexchangespecifiedcashflows.Forexample,inaninterestrateswap,twopartiesexchangeinterestpaymentsbasedonanotionalprincipalamount.However,theswapdoesnotinvolveanychangeintherelationshipsbetweentheswappartiesandtheirrespectiveprovidersofdebtfinance,sothestatementinDisfalse,makingitthecorrectanswer.
MORE:
FinancialInstitutions,InstrumentsandMarkets5/e,pp.780–781.
Thegrowthofswapsisaccountedforbytheirexceptionalversatilityfromthepointofviewofbothborrowersandinvestors.Swapsmaybeusedtohedgeinterestraterisk,exchangerateriskandcreditriskassociatedwithexistingorexpectedtransactions.Certainswaptransactionsmayalsobeusedtoachievealowercostoffundsforaborrower,orahigheryieldforaninvestor,thanwouldotherwisebeattainedwithoutaswaparrangement.Swapsmayalsobeusedtoopenupnewfundingorriskmanagementtechniques.
Question2:
OssieLimitedisabouttoestablishanewfundingarrangement.Itisabletoborrowineitherthefixedrateorfloatingratedebtmarkets.Thecompany’streasurerwishestoloweritscostofborrowingbyenteringintoaswaptransactionwithBattlerLimited.Basedonthefollowingdataforthetwocompanies,inwhichinterestratemarketwillOssieLimitedborrowandswapinto?
OssieLimitedfixedrate10.8percentperannum;floatingrateBBSW+0.3percentperannum.
BattlerLimitedfixedrate11.5percentperannum;floatingrateBBSW+1.7percentperannum.
A:
borrowatfixedrate,swapintofloatingrate
B:
borrowatfloatingrate,swapintofixedrate
C:
borrowatfixedrate;noadvantageinswaptransaction
D:
borrowatfloatingrate;noadvantageinswaptransaction
Feedback:
InthefixedratemarketOssiecanborrowat0.7percentperannumlessthanBattler,butinthefloatingratemarketOssie’sadvantageis1.4percentperannum.Therefore,Ossiehasacomparativeadvantageinthefloatingratemarketandthereisanetadvantageof0.7percentperannumassociatedwithaswap,soBisthecorrectanswer.
MORE:
FinancialInstitutions,InstrumentsandMarkets5/e,p.782.
ThecurrentcostsoffundsfortwoborrowersareprovidedinTable20.1.FirmAcanborrowfixed-interest-ratefundsat12.00percentperannum,orfloating-ratefundsatthebankbillswaprate(BBSW)plus50basispoints.(Note:
ifthefloating-rateborrowingoccurredintheinternationalcapitalmarkets,LIBORwouldtypicallybethereferencerateratherthanBBSW.)Inthisexampletheotherborrower(firmB)islesscreditworthyandthereforeitscostofborrowingincludesahigherriskpremium.FirmBcanborrowatafixedrateof14.00percentperannum,orafloatingrateatBBSW+1.70percent.Thedifferencesintheriskpremiumsforthetwoborrowersare2.00percentperannumforfixed-interestdebtand1.20percentperannumforfloating-ratedebt.Thatis,thedifferenceinthefixed-ratemarketiscomparativelygreater.FirmAhasacreditadvantageinboththefixed-andfloating-ratemarkets,butithasacomparativeadvantageinthefixed-ratemarket.Thenetdifferenceof0.80percentperannumrepresentsapotentialreductioninoverallborrowingcoststhatmaybemadethroughaswaptransactionbetweenthetwoparties.Comparativeadvantageisdiscussedinmoredetaillaterinthechapter.
RefertoTable20.1.
Inordertosetuptheappropriateswapstructureandobtainthebenefitofthepotentiallylowerborrowingcost,firmAshouldborrowinthemarketinwhichithasthegreatestcomparativeadvantageandborrowinthefixed-ratedebtmarket;thereforefirmBshouldborrowinthefloating-ratedebtmarket.Theseborrowingswillthenformtheunderlyingbasisofthenotionalprincipalamountoftheswap.Thefirmsshouldthenswaptheirrespectiveinterestpayments.
Question3:
MegaBankhasintermediatedamatchedswapfacilitywithtwoclientcompanies.Whichofthefollowingstatementsbestdescribesamatchedswap?
A:
theroleofthebankisthatofanagentinbringingthetwocompaniestogether
B:
thenotionalprincipalamountsareexchangedandmatchedbycurrencyandmaturity
C:
thebankasintermediaryeffectivelyentersintoseparateoffsettingcontracts
D:
alloftheabove
Feedback:
Amatchedswapinvolvesabankorothersimilarinstitutionsenteringintoseparatebutoffsettingswapswithtwootherparties.Thebankactsasanintermediary,notasanagent,andprincipalamountsarenotexchanged,soA,BandDareincorrectandCisthecorrectanswer.
MORE:
FinancialInstitutions,InstrumentsandMarkets5/e,p.784.
Intheaboveswaptwocompaniesdealtdirectlywitheachother;thatis,itwasadirectswap.However,themajorityofswapsinvolveacommercialbank,aninvestmentbankoramerchantbankactingasanintermediary.Thefinancialintermediarywillmostoftenseektoengageinanoffsettingswap,alsoknownasamatchedswap;thatis,thebankwillenterintoswapswithbothfirmAandfirmB.Theintroductionofanintermediarywillresultintwoseparateswaptransactions.ThebankwouldactasthecounterpartytofirmAand,separately,asthecounterpartytofirmB.Byestablishingamatchedswap,theintermediaryeffectivelyhasnonetexposureinthemarket.Theintermediarymakesitsprofitbymaintainingaspreadbetweentheratesatwhichitdealswiththetwocounterparties.ThisisillustratedinFigure20.2,inwhichtheintermediaryachievesanetspreadof0.10percentperannum.
Question4:
Whichofthefollowingmaybearguedascreatingadebtmarketenvironment,wherebyonecompanymayobtainacomparativeadvantageoveranothercompanyinthefixedinterestratemarket,comparedwiththefloatinginterestratemarket?
A:
theexistenceofsegmentationbetweenthefixedandfloatingratemarkets
B:
typically,fixedratemarketriskpremiumsarebasedonexternalcreditratingagencyreports
C:
professionalinstitutionallenders,suchasbanksandmerchantbanks,applytheirowninternalcreditriskpremiums
D:
alloftheabove
Feedback:
ThefactorsthatmaygiverisetodifferentriskpremiumsforgivenborrowersinthefixedandfloatingratedebtmarketsincludeallthoseoutlinedinA,BandC,soDisthecorrectanswer.
MORE:
FinancialInstitutions,InstrumentsandMarkets5/e,p.786.
Thisraisesthequestionofwhythedifferentialinthecreditriskofthetwoborrowerscouldvarybetweenthefixed-rateandfloating-ratemarkets.ItmightbepresumedthatthehighercreditriskpremiumpaidbyfirmBshouldbethesameinbothmarkets.Differentialriskpremiumsaremostlikelytooccurwherethereissomedegreeofmarketsegmentationbetweenthefixed-rateandfloating-ratedebtmarkets.Suchsegmentationmayexistifthelendersinthetwomarketsaredifferent.Forexample,lifeinsuranceoffices,superannuationfundsandunittrustfundsmanagerstendtobecomparativelymoresignificantlendersinthefixed-interestmarket,whilecommercialbanksarecomparativelymoresignificantlendersinthefloating-ratemarket.
Lenderswillimposearelativelyhigherriskpremiumforthelesscreditworthyborrower,thatis,theborrowerwiththehighercreditriskpotential(inthisinstance,firmB).ManymarketparticipantsrelyonthecreditratingsprovidedbyexternalratingsagenciessuchasStandard&Poor’sorMoody’sInvestorsServicetoascertainthelevelofcreditriskassociatedwithaborrower.Ontheotherhand,banksandotherfinancialinstitutionshavetheirowndepartmentsdevotedtotheassessmentofthecreditriskofborrowersandarefarlessdependentontheratingsofthecreditratingagencies.Itisquiteconceivablethatthelenderwillhaveamuchgreaterknowledgeoftheborrowers’futureprospectsthanwilltheexternalcreditratingsagencies,especiallyforborrowerswithwhomtheinstitutionallendersalreadyhaveabusinessrelationship.Asaresult,itshouldnotbesurprisingthattheassessmentoftheriskofborrowers,andthustheriskpremiumsandultimatelythecostoffunds,bytheprofessionalinstitutionallendersandtheexternalcreditratingsagenciesmaybedifferent.
Question5:
Acorporationhasafloatingrateloan.Whichofthefollowingisnotcorrect?
A:
thecorporationwillgainifinterestratesfallandloseifinterestratesrise
B:
thecorporationcouldobtainafixedcostoffundsbyenteringintoaninterestrateswap
C:
toprovidethecorporationwithafixedcostoffunds,aninterestrateswapshouldinvolvethecorporationpayingafixedrateandreceivingpaymentsbasedonafloatingrate
D:
toprovidethecorporationwithafixedcostoffunds,aninterestrateswapshouldinvolvethecorporationpayingafloatingrateandreceivingpaymentsbasedonafixedrate
Feedback:
ThestatementsinAandBarebothtrue.Sincethecorporationispayingafloatingrate,aninterestrateswapdesignedtofixthecostoffundsshouldinvolve