Swaps

Correct Answer: XYZ Corp and ABC Bank should enter into an interest rate swap where XYZ Corp pays floating and receives fixed, while ABC Bank pays fixed and receives floating. This allows XYZ Corp to effectively convert its fixed-rate debt to floating-rate, benefiting from the expected decline in interest rates.

The most appropriate type of swap for XYZ Corp and ABC Bank to enter into is an interest rate swap where XYZ Corp pays floating and receives fixed, while ABC Bank pays fixed and receives floating. XYZ Corp has issued fixed-rate bonds in USD but believes that US interest rates are likely to decline. By entering into an interest rate swap where it pays floating and receives fixed, XYZ Corp can effectively convert its fixed-rate debt to floating-rate debt. This allows the company to benefit from the expected decline in interest rates, as its interest payments will decrease when rates fall. On the other hand, ABC Bank has floating-rate assets and wants to hedge its interest rate risk. By entering into the interest rate swap and paying fixed while receiving floating, ABC Bank can lock in a fixed rate on its assets, protecting itself from potential interest rate declines. A currency swap is not appropriate in this case, as XYZ Corp's bonds are already denominated in USD, and there is no mention of ABC Bank having EUR-denominated debt. The primary objective is to manage interest rate risk, not currency risk. A credit default swap is also not suitable because XYZ Corp is not seeking protection against default on its bonds. Instead, the company wants to take advantage of the expected decline in interest rates.

Correct Answer: The risk that changes in market conditions will adversely impact the value of the swap agreement, potentially leading to losses for the counterparty

The best answer is that market risk associated with using a swap agreement for hedging purposes is the risk that changes in market conditions will adversely impact the value of the swap agreement, potentially leading to losses for the counterparty. This is because swap agreements are subject to market fluctuations, and changes in interest rates, exchange rates, or other market factors can affect the value of the swap. If market conditions move unfavorably, the value of the swap may decline, resulting in potential losses for the counterparty. The other answers are incorrect because they describe different types of risks: - Counterparty risk, which is the risk that the other party in the swap agreement fails to fulfill its obligations. - Basis risk, which is the risk that the underlying asset or liability being hedged experiences price movements that are not perfectly offset by the swap, leading to residual exposure.

Correct Answer: Swaps allow for the exchange of cash flows without the need to transfer the underlying principal amounts.

A key advantage of using swap agreements for hedging is that they allow for the exchange of cash flows based on the underlying assets or liabilities without requiring the transfer of the principal amounts. Swaps provide a way to manage and mitigate specific risks associated with the underlying assets or liabilities, but they do not completely eliminate all risks. Swaps involve the exchange of cash flows, but typically do not involve transferring the ownership of the underlying assets or liabilities between the parties.