Question 1
Multiple ChoiceThe value of an interest rate swap that exchanges fixed payments for floating payments is most likely:
Explanation
While the price of a swap (the fixed rate) is set at initiation and remains constant, the value of the swap changes over time based on interest rate movements. If market rates move away from the fixed rate agreed at initiation, the present value of future net payments changes, which alters the value of the swap.
Question 2
Multiple ChoiceTrident Capital enters into a pay-fixed, receive-floating interest rate swap with a notional amount of $10 million and a 5-year maturity. If market expectations shift and implied forward interest rates increase, which of the following best describes the impact on Trident’s position?
Explanation
A pay-fixed position becomes less favorable when forward rates rise because the fixed payments remain constant, while the present value of the floating payments increases. This causes a mark-to-market loss for the pay-fixed counterparty.
Question 3
Multiple ChoiceSierra Finance has entered a receive-fixed, pay-floating interest rate swap with a corporate client. At the first reset date, the floating reference rate sets at 4.8%, which is above the fixed swap rate of 4.2%. Which of the following best describes Sierra Finance’s net cash flow at the first settlement?
Explanation
When the floating rate is above the fixed rate, the pay-floating (receive-fixed) counterparty must make a net payment on the swap. This occurs because their obligation under the floating leg exceeds their inflow from the fixed leg.
Question 4
Multiple ChoiceBayshore Investments enters into a 3-year interest rate swap agreement with a notional principal of $20 million. On the trade date, the fixed rate is set at 3.75%, which reflects the current market swap rate. Ignoring counterparty risk and transaction costs, what is the value of the swap to either party at initiation?
Explanation
At initiation, the swap is priced such that the present value of the fixed and floating payments is equal, making the initial value of the contract zero for both parties. This ensures no arbitrage opportunity exists at inception.
Question 5
Multiple ChoiceWhich of the following statements about interest rate swaps and their relationship to forward contracts is most accurate?
Explanation
Interest rate swaps can be interpreted as a series of forward rate agreements (FRAs) with different maturities. Although the fixed rate is constant across the life of the swap, the individual forward contracts within it have varying values depending on the term structure of interest rates. However, the sum of their values at initiation is zero, making the overall swap fair at inception.
Question 6
Multiple ChoiceMadison Holdings is an institutional investor whose portfolio includes fixed-rate municipal bonds that are set to mature in two months. The firm plans to reinvest the proceeds into seven-year fixed-rate securities at that time but is concerned about reinvestment rate uncertainty. Which of the following strategies best addresses Madison’s reinvestment risk?
Explanation
To hedge reinvestment risk associated with future fixed-income purchases, the investor should receive fixed in a forward-starting swap. This mimics the return profile of locking in the yield on a future fixed-rate bond. If interest rates fall, the swap gains in value—offsetting the lower reinvestment rate. This strategy effectively hedges the reinvestment rate risk.
Question 7
Multiple ChoiceCrescent Derivatives enters into a 7-year EUR interest rate swap where it agrees to receive a floating EURIBOR rate of 2.10% and pay a fixed rate of 3.50%. Three months after the start of the swap, the first floating payment has been set, but no payments have occurred yet. Which of the following best describes the value of the swap to Crescent at this point?
Explanation
At inception, the swap is valued so that the present value of expected floating and fixed payments is equal, making the value zero. After inception, even if one cash flow is known, we cannot determine the current value of the swap without knowing updated forward rates to revalue future expected cash flows. Therefore, more information is required to assess whether Crescent has a gain or loss.
Question 8
Multiple ChoiceBarclay Partners enters a 15-year USD interest rate swap where it receives floating payments based on 1.90% and pays a fixed rate of 3.20% semiannually. Six months after initiation, the first net payment has been made, and forward interest rate expectations remain unchanged since the swap began. Which of the following best describes the current value of the swap from Barclay’s perspective?
Explanation
Since the fixed rate paid was greater than the floating rate received in the first period, Barclay made a net payment. However, if forward rates have not changed since initiation, the swap was fairly priced at the start. Now that the first (unfavorable) payment is behind them, the value of the remaining future cash flows—based on the initial forward curve—is favorable to Barclay. Hence, the swap has a positive value (MTM gain) to Barclay.