Interest Rate and Currency Swaps
CHAPTER 14 INTEREST RATE AND CURRENCY SWAPS
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Describe the difference between a swap broker and a swap dealer.
Answer: A swap broker arranges a swap between two counterparties for a fee without taking a risk position in the swap. A swap dealer is a market maker of swaps and assumes a risk position in matching opposite sides of a swap and in assuring that each counterparty fulfills its contractual obligation to the other. 2. What is the necessary condition for a fixed-for-floating interest rate swap to be possible?
Answer: For a fixed-for-floating interest rate swap to be possible it is necessary for a quality spread differential to exist. In general, the default-risk premium of the fixed-rate debt will be larger than the default-risk premium of the floating-rate debt.
3. Discuss the basic motivations for a counterparty to enter into a currency swap.
Answer: One basic reason for a counterparty to enter into a currency swap is to exploit the comparative advantage of the other in obtaining debt financing at a lower interest rate than could be obtained on its own. A second basic reason is to lock in long-term exchange rates in the repayment of debt service obligations denominated in a foreign currency.
4. How does the theory of comparative advantage relate to the currency swap market?
Answer: Name recognition is extremely important in the international bond market. Without it, even a creditworthy corporation will find itself paying a higher interest rate for foreign denominated funds than a local borrower of equivalent creditworthiness. Consequently, two firms of equivalent creditworthiness can each exploit their, respective, name recognition by borrowing in their local capital market at a favorable rate and then re-lending at the same rate to the other.
5. Discuss the risks confronting an interest rate and currency swap dealer.
Answer: An
SUGGESTED ANSWERS AND SOLUTIONS TO END-OF-CHAPTER
QUESTIONS AND PROBLEMS
QUESTIONS
1. Describe the difference between a swap broker and a swap dealer.
Answer: A swap broker arranges a swap between two counterparties for a fee without taking a risk position in the swap. A swap dealer is a market maker of swaps and assumes a risk position in matching opposite sides of a swap and in assuring that each counterparty fulfills its contractual obligation to the other. 2. What is the necessary condition for a fixed-for-floating interest rate swap to be possible?
Answer: For a fixed-for-floating interest rate swap to be possible it is necessary for a quality spread differential to exist. In general, the default-risk premium of the fixed-rate debt will be larger than the default-risk premium of the floating-rate debt.
3. Discuss the basic motivations for a counterparty to enter into a currency swap.
Answer: One basic reason for a counterparty to enter into a currency swap is to exploit the comparative advantage of the other in obtaining debt financing at a lower interest rate than could be obtained on its own. A second basic reason is to lock in long-term exchange rates in the repayment of debt service obligations denominated in a foreign currency.
4. How does the theory of comparative advantage relate to the currency swap market?
Answer: Name recognition is extremely important in the international bond market. Without it, even a creditworthy corporation will find itself paying a higher interest rate for foreign denominated funds than a local borrower of equivalent creditworthiness. Consequently, two firms of equivalent creditworthiness can each exploit their, respective, name recognition by borrowing in their local capital market at a favorable rate and then re-lending at the same rate to the other.
5. Discuss the risks confronting an interest rate and currency swap dealer.
Answer: An