MaxMarkCh20QuestionsOnly.docx

1、MaxMarkCh20QuestionsOnlyMaxMarkVineyMenuItem 20: (Topic 20)Interest rate swaps, currency swaps and credit default swapsQuestion 1: The treasurer of Multinational Limited has been asked by the board of directors to conduct a review of its existing funding strategies and financial risk management tech

2、niques. Within the review, the treasurer will report on the advantages of the interest rate and currency swap transactions that are currently used by the company. Which of the following is generally not an advantage of these swap transactions?A: allowing the company to achieve a lower cost of fundsB

3、: hedging of both interest rate risk and foreign exchange riskC: facilitating the restructure of cash flows associated with existing borrowingsD: transferring the counterparty exposure of the original funding arrangementFeedback: A swap involves two parties agreeing to exchange specified cash flows.

4、 For example, in an interest rate swap, two parties exchange interest payments based on a notional principal amount. However, the swap does not involve any change in the relationships between the swap parties and their respective providers of debt finance, so the statement in D is false, making it t

5、he correct answer.MORE: Financial Institutions, Instruments and Markets 5/e, pp. 780781.The growth of swaps is accounted for by their exceptional versatility from the point of view of both borrowers and investors. Swaps may be used to hedge interest rate risk, exchange rate risk and credit risk asso

6、ciated with existing or expected transactions. Certain swap transactions may also be used to achieve a lower cost of funds for a borrower, or a higher yield for an investor, than would otherwise be attained without a swap arrangement. Swaps may also be used to open up new funding or risk management

7、techniques.Question 2: Ossie Limited is about to establish a new funding arrangement. It is able to borrow in either the fixed rate or floating rate debt markets. The companys treasurer wishes to lower its cost of borrowing by entering into a swap transaction with Battler Limited. Based on the follo

8、wing data for the two companies, in which interest rate market will Ossie Limited borrow and swap into?Ossie Limited fixed rate 10.8 per cent per annum; floating rate BBSW + 0.3 per cent per annum.Battler Limited fixed rate 11.5 per cent per annum; floating rate BBSW + 1.7 per cent per annum.A: borr

9、ow at fixed rate, swap into floating rateB: borrow at floating rate, swap into fixed rateC: borrow at fixed rate; no advantage in swap transactionD: borrow at floating rate; no advantage in swap transactionFeedback: In the fixed rate market Ossie can borrow at 0.7 per cent per annum less than Battle

10、r, but in the floating rate market Ossies advantage is 1.4 per cent per annum. Therefore, Ossie has a comparative advantage in the floating rate market and there is a net advantage of 0.7 per cent per annum associated with a swap, so B is the correct answer.MORE: Financial Institutions, Instruments

11、and Markets 5/e, p. 782.The current costs of funds for two borrowers are provided in Table 20.1. Firm A can borrow fixed-interest-rate funds at 12.00 per cent per annum, or floating-rate funds at the bank bill swap rate (BBSW) plus 50 basis points. (Note: if the floating-rate borrowing occurred in t

12、he international capital markets, LIBOR would typically be the reference rate rather than BBSW.) In this example the other borrower (firm B) is less creditworthy and therefore its cost of borrowing includes a higher risk premium. Firm B can borrow at a fixed rate of 14.00 per cent per annum, or a fl

13、oating rate at BBSW + 1.70 per cent. The differences in the risk premiums for the two borrowers are 2.00 per cent per annum for fixed-interest debt and 1.20 per cent per annum for floating-rate debt. That is, the difference in the fixed-rate market is comparatively greater. Firm A has a credit advan

14、tage in both the fixed- and floating-rate markets, but it has a comparative advantage in the fixed-rate market. The net difference of 0.80 per cent per annum represents a potential reduction in overall borrowing costs that may be made through a swap transaction between the two parties. Comparative a

15、dvantage is discussed in more detail later in the chapter.Refer to Table 20.1.In order to set up the appropriate swap structure and obtain the benefit of the potentially lower borrowing cost, firm A should borrow in the market in which it has the greatest comparative advantage and borrow in the fixe

16、d-rate debt market; therefore firm B should borrow in the floating-rate debt market. These borrowings will then form the underlying basis of the notional principal amount of the swap. The firms should then swap their respective interest payments.Question 3: Mega Bank has intermediated a matched swap

17、 facility with two client companies. Which of the following statements best describes a matched swap?A: the role of the bank is that of an agent in bringing the two companies togetherB: the notional principal amounts are exchanged and matched by currency and maturityC: the bank as intermediary effec

18、tively enters into separate offsetting contractsD: all of the aboveFeedback: A matched swap involves a bank or other similar institutions entering into separate but offsetting swaps with two other parties. The bank acts as an intermediary, not as an agent, and principal amounts are not exchanged, so

19、 A, B and D are incorrect and C is the correct answer.MORE: Financial Institutions, Instruments and Markets 5/e, p. 784.In the above swap two companies dealt directly with each other; that is, it was a direct swap. However, the majority of swaps involve a commercial bank, an investment bank or a mer

20、chant bank acting as an intermediary. The financial intermediary will most often seek to engage in an offsetting swap, also known as a matched swap; that is, the bank will enter into swaps with both firm A and firm B. The introduction of an intermediary will result in two separate swap transactions.

21、 The bank would act as the counterparty to firm A and, separately, as the counterparty to firm B. By establishing a matched swap, the intermediary effectively has no net exposure in the market. The intermediary makes its profit by maintaining a spread between the rates at which it deals with the two

22、 counterparties. This is illustrated in Figure 20.2, in which the intermediary achieves a net spread of 0.10 per cent per annum.Question 4: Which of the following may be argued as creating a debt market environment, whereby one company may obtain a comparative advantage over another company in the f

23、ixed interest rate market, compared with the floating interest rate market?A: the existence of segmentation between the fixed and floating rate marketsB: typically, fixed rate market risk premiums are based on external credit rating agency reportsC: professional institutional lenders, such as banks

24、and merchant banks, apply their own internal credit risk premiumsD: all of the aboveFeedback: The factors that may give rise to different risk premiums for given borrowers in the fixed and floating rate debt markets include all those outlined in A, B and C, so D is the correct answer.MORE: Financial

25、 Institutions, Instruments and Markets 5/e, p. 786.This raises the question of why the differential in the credit risk of the two borrowers could vary between the fixed-rate and floating-rate markets. It might be presumed that the higher credit risk premium paid by firm B should be the same in both

26、markets. Differential risk premiums are most likely to occur where there is some degree of market segmentation between the fixed-rate and floating-rate debt markets. Such segmentation may exist if the lenders in the two markets are different. For example, life insurance offices, superannuation funds

27、 and unit trust funds managers tend to be comparatively more significant lenders in the fixed-interest market, while commercial banks are comparatively more significant lenders in the floating-rate market.Lenders will impose a relatively higher risk premium for the less creditworthy borrower, that i

28、s, the borrower with the higher credit risk potential (in this instance, firm B). Many market participants rely on the credit ratings provided by external ratings agencies such as Standard & Poors or Moodys Investors Service to ascertain the level of credit risk associated with a borrower. On the ot

29、her hand, banks and other financial institutions have their own departments devoted to the assessment of the credit risk of borrowers and are far less dependent on the ratings of the credit rating agencies. It is quite conceivable that the lender will have a much greater knowledge of the borrowers f

30、uture prospects than will the external credit ratings agencies, especially for borrowers with whom the institutional lenders already have a business relationship. As a result, it should not be surprising that the assessment of the risk of borrowers, and thus the risk premiums and ultimately the cost

31、 of funds, by the professional institutional lenders and the external credit ratings agencies may be different.Question 5: A corporation has a floating rate loan. Which of the following is not correct?A: the corporation will gain if interest rates fall and lose if interest rates riseB: the corporati

32、on could obtain a fixed cost of funds by entering into an interest rate swapC: to provide the corporation with a fixed cost of funds, an interest rate swap should involve the corporation paying a fixed rate and receiving payments based on a floating rateD: to provide the corporation with a fixed cos

33、t of funds, an interest rate swap should involve the corporation paying a floating rate and receiving payments based on a fixed rateFeedback: The statements in A and B are both true. Since the corporation is paying a floating rate, an interest rate swap designed to fix the cost of funds should involve