MaxMarkCh20QuestionsOnly.docx

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