(CMSA) SWAP FUNDAMENTALS EXAM QUESTIONS AND ANSWERS WITH COMPLETE SOLUTIONS LATEST UPDATE RATED PASS!!!

(CMSA) SWAP FUNDAMENTALS EXAM QUESTIONS AND ANSWERS WITH COMPLETE SOLUTIONS LATEST UPDATE RATED PASS!!! Define Swap Is a derivative in which two counterparties exchange cash flows of equal expected values at periodic intervals *Often one leg is a fixed payment while the other is a floating payment Characteristics of swaps 1. Traded OTC between financial institutions and market makers 2. One of the parties is a swap dealer (Swap Bank) and is usually a large bank 3. The bank offsets a swap through an inter-dealer broker after it executes the swap 4. The NPV of both payment streams must be the same 5. Maturity is usually between 1-5 years 6. Swaps are usually used for hedging, speculating, or managing risk What are the different types of swaps? 1. Interest Rate Swap 2. Currency Swaps 3. Equity Swaps 4. Basis Swaps 5. Commodity Swap Describe the structure of an interest rate swap An interest rate swap is the exchange of fixed interest payments for floating rate payments between two parties. Usually one of the parties is a swap dealer (Swap Bank) *Interest payments are netted, and the party that owes more in interest at a settlement date makes a payment equal to the difference to the other party What is the formula for a vanilla interest rate swap? Net Fixed Rate Payment Made (Received) by Fixed Payer = [Swap Fixed Rate - (Floating Rate)](#Days/360)Notional Principal What are the Key Features of an interest rate swap? Term - Normally 2 and 30 years Notional Amount - The notional amount is not paid or received but is used to calculate the cash flows Payment Frequency - Payments are typically made either quarterly, semi-annually or annually Floating Rate - This is normally based on LIBOR & it is used to reset the swap throughout the swap term thus each floating payment will be different Fixed Rate - This is set at the beginning of the swap and is also known as the swap rate Payer/Receiver - In a payer swap you pay the fixed leg and receive the floating leg, and vice versa for a receiver swap Describe Long Swap (Buyer) You receive LIBOR but pay fixed Bond Equivalent: Long float bond & Short fixed bond Value of Swap (Long) = V(Float) - V(Fixed) Describe Short Swap (Seller) You receive fixed but pay LIBOR Bond Equivalent: Short float bond & Long fixed bond Value of Swap (Short) = V(Fixed) - V(Float) What is the underlying motive behind an interest rate swap? One party wants greater certainty for their cash flow , while the other looks for potentially larger returns (IRS) Interest Rate Swaps can be used to increase or decrease the interest rate exposure A portfolio manager making investment decisions for a bond fund will often have a view on the future direction of interest rate swaps Which position should you take if you want to increase exposure or decrease? Increase Interest Rate Exposure = Receive Fixed & Pay floating (When interest rates decrease the profit made on the swap adds to the performance of the fund) Decrease Interest Rate Exposure = Pay Fixed & Receive Floating (When interest rates increase the profit made on the swap offsets the losses on the fund) Three reasons why you should use Swaps? 1. Speculative Trading (Requires little capital speculates on movements of interest rates while avoiding the cost of long & short positions) 2. Entering New Markets (Arbitrage Opportunities) 3. Managing Risk (Firms with floati