Exam 8: Interest Risk and Swaps

The potential exposure that any individual firm bears that the second party to any financial contract will be unable to fulfill its obligations under the contract is called:

Instruction 8.1: For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. -Refer to Instruction 8.1. If your firm felt very confident that interest rates would fall or, at worst, remain at current levels, and were very confident about the firm's credit rating for the next 10 years, which strategy would you likely choose? (Assume your firm is borrowing money.)

Your firm is faced with paying a variable rate debt obligation with the expectation that interest rates are likely to go up. Identify two strategies using interest rate futures and interest rate swaps that could reduce the risk to the firm.

Your firm is faced with paying a variable rate debt obligation with the expectation that interest rates are likely to go up. Identify two strategies using interest rate futures and interest rate swaps that could reduce the risk to the firm.

Some of the world's largest and most financially sound firms may borrow at variable rates less than LIBOR.

Historically, interest rate movements have shown less variability and greater stability than exchange rate movements.

Instruction 8.1: For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. -Refer to Instruction 8.1. After the fact, under which set of circumstances would you prefer strategy #3? (Assume your firm is borrowing money.)

Which of the following is an unlikely reason for firms to participate in the swap market?

Instruction 8.1: For the following problem(s), consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. -Refer to Instruction 8.1. Choosing strategy #3 will:

A swap agreement may involve currencies or interest rates, but never both.

A firm with fixed-rate debt that expects interest rates to fall may engage in a swap agreement to:

If a financial manager earning interest on a future date were to buy Futures and interest rates end up going up, the position outcome would be:

Counterparty risk is greater for exchange-traded derivatives than for over-the-counter derivatives.

The London Interbank Offered Rate (LIBOR) is published under the auspices of the British Bankers Association. A panel of 16 major multinational banks self-report their actual borrowing rate.

An interbank-traded contract to buy or sell interest rate payments on a notional principal is called a/an:

One of the reasons companies use interest rate swaps is because they are interested in opportunities to lower the cost of their debt.

Sovereign credit risk is the global financial market's assessment of the ability of a sovereign borrower to repay USD denominated debt.

Interest rate calculations differ by the number of days used in the period's calculation and in the definition of how many days there are in a year (for financial purposes). One of the practices is to use 260 business days in a year.

The basis point spreads between credit ratings dramatically rise for borrowers of credit qualities less than BBB.

Unlike the situation with exchange rate risk, there is no uncertainty on the part of management for shareholder preferences regarding interest rate risk. Shareholders prefer that managers hedge interest rate risk rather than having shareholders diversify away such risk through portfolio diversification.