Ch.7 Complete Test Bank Currency Swaps And Swaps Markets

Chapter 7 Currency Swaps and Swaps Markets

Notes to instructors:

Answers to non-numeric multiple choice questions are arranged alphabetically, so that answers are randomly assigned to the five outcomes.

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1. A currency swap is an agreement to exchange a principal amount of two different currencies and, after a prearranged length of time, to reexchange the original principal.

2. Interest payments are typically exchanged during the life of a swap agreement.

3. Currency swaps are usually used to hedge short-term currency risks.

Swaps usually involve long-term exposures to financial price risks.

4. An interest rate swap is a currency swap in which the principal amounts are in a single currency.

5. In an interest rate swap, the principal amount is called notional principal because it is used only to calculate interest payments and is not exchanged.

6. Currency forwards, futures, options, and swaps are derivative securities that are exposed to currency risk.

7. If one party defaults in a swap, it does not release the other party from its obligation.

Swaps combine all cash flows into a single legal contract.

8. The market for “plain vanilla” swaps is a low-volume, high-margin business.

Quite the opposite.

9. The currency coupon swap is a fixed-for-floating rate nonamortizing currency swap.

10. Growth in the swaps market occurred primarily in the 1970s.

Growth has been very high in the 1980s, 1990s, and 2000s.

11. In most countries, currency swaps must be capitalized on the balance sheet.

In most countries, currency swaps appear in footnotes rather than on the balance sheet.

12. The majority of the volume in the currency swaps market is conducted on organized exchanges.

Swaps are traded through commercial and investment banks.

13. A swap contract identifies the currencies of denomination and the amount and timing of all future cash inflows and outflows.

14. A swap contract releases each party from its obligation should the other party default.

15. Currency swaps have little relation to currency forward contracts.

Swaps are in fact a bundle of forward contracts of different maturities.

16. A swap is a bundle of end-to-end options in which one option is followed by another upon exercise.

A swap is a bundle of simultaneous forward contracts, each with a different maturity date.

17. Default risk in a swap contract is comparable to default risk in a straight debt issue.

The risk and consequences of default are far less than for straight debt.

18. Currency coupon swaps are agreements to exchange fixed rate debt in one currency for floating rate debt in another currency.

19. In an interest rate swap, only the difference check between the interest payments is exchanged when interest payments are due.

20. Swaps generally do not require a performance bond such as a margin requirement, and this tends to give swaps slightly more default risk than a comparable futures contract.

21. The default risk of a swap contract falls somewhere between the risk of a comparable futures contract and the risk of the forward contract with the longest maturity in the bundle of forward contracts that comprises the swap.

22. Swaps are similar in default risk to straight debt.

Swaps are far less risky than straight debt.

Multiple Choice Select the BEST ANSWER

1. Which of (a) through (d) is not of a swap if the principal amounts are in the same currency?

a. The notional principal is exchanged.

b. The swap is an interest rate swap.

c. The principal amount is used to calculate the interest payments.

d. Only the difference check between the two interest payments is exchanged.

e. All of the above are

2. Dealers quote swap prices in a(n) ____.

a. difference check

b. notional principal

c. option contract

d. pricing schedule

e. none of the above

3. A fixed-for-floating nonamortizing currency swap is called a ____.

a. commodity swap

b. coupon swap

c. currency coupon swap

d. debt-for-equity swap

e. swaption

4. A fixed-for-floating interest rate swap is called a ____.

a. commodity swap

b. coupon swap

c. currency coupon swap

d. debt-for-equity swap

e. swaption

5. A swap with one or more options attached is called a ____.

a. commodity swap

b. coupon swap

c. currency coupon swap

d. debt-for-equity swap

e. swaption

6. A bank’s swap portfolio is called its ____.

a. difference check

b. pricing schedule

c. notional principal

d. swap book

e. swap contract

Problem

1. A swap dealer quotes a euro midrate of 3.8175 percent in bond equivalent yield with quarterly compounding for a two-year yen-per-euro currency coupon swap. The corresponding two-year yen rate is 2.9291 percent in quarterly compounded bond equivalent yield. The dealer charges an annual fee of ±8bp (±2bp per quarter) around the euro swap mid-rate against yen three-month LIBOR flat. The swap pricing schedule looks like this:

Currency Coupon Swap Pricing Schedule

Maturity Bid (in €) Ask (in €)

2 years 3.7375% 3.8975%

Quotes are against 1-year LIBOR Euroyen flat.

The spot exchange rate is ¥168.264/€.

Useful present value interest factors for annuities (PVIFA) include:

PVIFA(8 periods at the 3.8175%/4 = 0.954375% euro rate) = 7.66707456

PVIFA(8 periods at the 2.9291%/4 = 0.732275% yen rate) = 7.74268838

a. NTT has ¥1,682,640,000 of two-year yen debt at a floating rate of three-month (¥) LIBOR + 88 bps (MMY), or LIBOR + 22 bps each three months. NTT wants to swap this into fixed rate euros to fund its European operations. What is the all-in cost of NTT’s yen-for-euro currency coupon swap? Verify this by calculating the internal rate of return on NTT’s fully covered ¥/€ swap.

b. EuroDigital, N.V. (ED) has €10 million of two-year fixed rate debt at 4.7508 percent in bond equivalent yield (BEY). ED wants floating rate yen debt to fund its expansion into Japan. Identify the all-in cost of ED’s ¥/€ currency coupon swap. Verify this cost by calculating the internal rate of return on ED’s fully covered cash flows.

c. What does the swap bank gain from these transactions?

Problem Solution

1. a. The three-month euro interest rate in the swap pricing schedule is (3.81750%/4) = 0.954375%. The corresponding three-month yen interest rate is (2.92910%/4) = 0.732275%. The PV annuity factors that correspond to these interest rates are PVIFA(i^¥ = 0.954375%,T = 8) = 7.6670746% and PVIFA(i^£ = 0.732275%,T = 8) = 7.7426884%. NTT’s 88 bps annual MMY spread to LIBOR translates into a bond equivalent yield of (0.88%/4)(365/360) = 0.223056%, or 22.3056 bps per three months. Solving equation (13.2) for the equivalent quarterly euro spread yields

r^€ = r^¥ PVIFA(i^¥ = 0.954375,T = 8)/ PVIFA(i^£ = 0.732275%,T = 8)

= (22.3056 bps)(7.66707456/7.74268838) = 22.5255 bps (BEY).

NTT pays the fixed rate side of the swap at a quarterly rate of (3.81750% + 8 bps)/4 = 0.974375%. NTT’s all-in cost of fixed rate euro debt is (0.974375% + 0. 225255%) = 1.199630 percent per quarter in bond equivalent yield.

This can be verified through the cash flows. NTT pays a floating rate yen cash flow of LIBOR + 22 bps (MMY) each three months, or (0.0022)(365/360) = 0.00223056 in quarterly BEY. This is a yen spread over LIBOR of (0.00223056)(¥1,682,640,000) = ¥3,753,222.

The swap offsets this yen spread to LIBOR with fixed rate euro CFs with the same present value through equation (13.2), or payments of (0.00225255)(€10,000,000) = €22,525.50 every three months. NTT also has to pay the 0.974375% swap rate, resulting in a quarterly payment of €97,437.50. The total quarterly interest rate is (0.225255% + 0.974375%) = 1.199630 percent, or (0.001199630)(£10,000,000) = €119,963.

This leaves a net payment of €119,963 every three months.

This is an all-in cost of (€119,963)(€10,000,000) = 0.0119963 per three months, or 4.798521 percent per year compounded quarterly. The effective annual rate is (1.0119963)⁴ – = 4.885561 percent.

b. ED is paying 4.7508 percent compounded quarterly, or (4.7508%)/4 = 1.1877 percent per quarter. The swap bank’s quarterly swap bid rate is (3.8175% – 0.08%)/4 = 0.934375 percent per quarter. The premium over the swap rate is thus (1.187700% – 0.934375%)/4 = 25.3325 bps per quarterly. The corresponding yen premium to LIBOR is r^¥ = r^€ PVIFA(i^€,8)/PVIFA(i^¥,8) = (25.3325 bps)(7.66707456/7.74268838) = 25.0851 bps (BEY), or (25.0851 bps)(360/365) = 24.7415 bps in money market yield. ED’s all-in cost of floating rate yen financing over the LIBOR yen rate is 4(24.7415 bps) = 0.989659% in money market yield.

The swap has quarterly fixed rate euro receipts of €118,770 offset by floating rate yen interest payments of (25.0851 bps)(¥1,682,640,000) = ¥3,887,679 (BEY) over LIBOR.

The net spread over LIBOR is then of ¥3,887,679 in bond equivalent yield every three months.

This is a money market spread of (25.0851 bps)(360/365) = 24.7415 bps, or 0.989659% per year compounded quarterly. The all-in cost of ED’s floating rate yen financing is thus LIBOR + about 0.989659% compounded semiannually.

ED’s underlying fixed rate obligation is (4.7508%/4)(€10,000,000) = –€118,770 per quarter.

The swap has quarterly fixed rate euro receipts of €118,770 offset by floating rate yen interest payments of (25.0851 bps)(¥1,682,640,000) = ¥4,220,920 (BEY) over LIBOR.

The net spread over LIBOR is then of ¥4,220,920 in bond equivalent yield every three months.

This is a money market spread of (25.0851 bps)(360/365) = 24.7415 bps, or 0.989659 percent per year compounded quarterly. The all-in cost of ED’s floating rate yen financing is thus LIBOR + about 0.989659% (MMY) compounded semiannually. The effective annual rate is (1.00247415)⁴ – 1 = 0.993338 percent in money market yield.

c. The swap bank earns a 16 bp spread in quarterly compounded bond equivalent yield on the notional principal regardless of whether the bank quotes fully covered rates or uses the swap pricing schedule given in the problem. When the bank quotes fully covered rates, it adds a premium to both the fixed and floating rate sides that leaves its net position unchanged in value. The annual percentage rate is (1.0004)⁴ – 1 = 0.00160096, or 16.0096 bp per year.