CHAPTER 14 INTEREST RATE AND CURRENCY SWAPS chapter end qs

CHAPTER 14 INTEREST RATE AND CURRENCY SWAPS chapter end qs...

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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.
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5. Discuss the risks confronting an interest rate and currency swap dealer. Answer: An interest rate and currency swap dealer confronts many different types of risk. Interest rate risk refers to the risk of interest rates changing unfavorably before the swap dealer can lay off on an opposing counterparty the unplaced side of a swap with another counterparty. Basis risk refers to the floating rates of two counterparties being pegged to two different indices. In this situation, since the indexes are not perfectly positively correlated, the swap bank may not always receive enough floating rate funds from one counterparty to pass through to satisfy the other side, while still covering its desired spread, or avoiding a loss. Exchange-rate risk refers to the risk the swap bank faces from fluctuating exchange rates during the time it takes the bank to lay off a swap it undertakes on an opposing counterparty before exchange rates change. Additionally, the dealer confronts credit risk from one counterparty defaulting and its having to fulfill the defaulting party’s obligation to the other counterparty.
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