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MBA Financial Swaps Very Short Sample Question Answer Model Paper

MBA Financial Swaps Very Short Sample Question Answer Model Paper

MBA Financial Swaps Very Short Sample Question Answer Model Paper

Financial swaps, managing interest rate exposure, Interest rate swaps, Currency swaps, Interest rate futures, Forward rate agreement.

Section A


Ques.1. What is the concept of swaps?

Ans. Swap is any agreement to a future exchange of one asset for another, one liability for another, more specifically, one stream of cash flows for another. A swap is a private agreement between two parties in which both parties are obligated to exchange some specified cash flows at periodic intervals for a fixed period of time. Unlike a forward or a future contract, a swap agreement involves multiple future points of exchange.

The cash flows of a swap may be fixed in advance or adjusted for each settlement date by reference to some specified interest rate on the settlement date, a difference cheque is paid by whichever party in the swap is obligated to pay more cash than is to be received at the settlement date. For example, an investor realising returns on equity investiment can swap those returns into less risky fixed income cash flows without having to liquidate for equities. A corporation with floating rate debt can swap that debt into a fixed obligation without having to retire and re-issue debt.

Ques.2. How swap can be used to manage risk?

Ans. Swap can be used to manage risk in the following ways:

  1. Swap can be used to transform floating rate assets into fixed rate assets and vice versa.
  2. Swap can be used to transform floating rate liabilities into fixed rate liabilities and vice versa.
  3. Swap can be used to transform behind any asset or liability into a different currency.
  4. Swap can be used to lower borrowing costs and generate higher investment returns.

Ques.3. What do you mean by interest rate exposure?

Ans. Interest rate risk is the chance that an unexpected change in interest rate will negatively affect the value of an investment. A bank’s main source of profit is converting the liabilities of deposits and borrowing into assets of loans and securities. It profits by paying a lower interest on its liabilities than it earns on its assets–the difference in these rates is the net interest margin. Banks make money by borrowing at short-term rate and lending at long-term rates.

Ques.4. Discuss about the management of interest rate risk.

Ans. Interest rate risk management is not purely managing the interest line in the profit and loss account. It also encapsulates the management of the whole debt profit of the business including the maturity of the debt, the currency of the debt, the fixed floating mixture of the debt and expectation future interest rates, Managing interest rate risk is a fundamental component in the safe and sound management of all institutions. It involves prudently managing mismatch positions in order to control, within set parameters, the impact of change in interest rates on the institutions. Significant factors in aging the risk include the frequency, volatility and direction of rate changes, the slope of the interest yield curve, the size of the interest, sensitive position and the basis for re-pricing at rollover date.

 Ques.5. Give reason for using interest rate swap.

Ans. Interest rate swaps are used by a wide range of commercial banks, investment ha financial operating companies, insurance companies, mortgage companies, investment vehicle trusts, government agencies and sovereign states for one or more of the following reasons:

  1. To lower the cost of funding.
  2. To create new types of investment assets not otherwise available.

. To implement the overall assets- liability management strategies.

  1. To make speculative positions in relation to future movements in interest rates.
  2. To hedge interest rate exposure.

Ques.6. What are currency swaps?

Ans. Currency swaps are derivative products that help to manage exchange rate and interest rate exposure on long-term liabilities. A currency swap involves exchange of interest payments denominated in two different currencies for a specified term, along with exchange of principals. The rate of interest in each log could either be a fixed rate, or a floating rate indexed to some reference rate, like the LIBOR.

In a typical currency swap, counterparties will perform the following:

  1. Exchange a stream of fixed or floating interest rate payments in their swapped currencies for the agreed period of the swap.
  2. After that, exchange equal initial principal amounts of two currencies at the spot exchange rate.
  3. Re-exchange the principal amount at maturity at the initial spot exchange rate.

Ques.7. What are the elements of currency swap?

Ans. A currency swap is a legal agreement consisting of at least two of the following elements: 1. A simultaneous arrangement to re-exchange the same quantity of currency, usually at exactly the same exchange rate, at a stipulated date in the medium to long-term (the far-value date that is at the swap’s maturity).

  1. A settlement for interest costs between the two parties for the duration of the swap is payable either at regular intervals (or six monthly or annually) or in a single settlement at maturity.
  2. An arrangement to buy or sell a given quantity of one currency in exchange for another, at an agreed rate on a stipulated date (the near value date), usually at the spot exchange rate (less typically at a forward or other stipulated rate).

Ques.8. What is the relation between currency swaps and interest rate swaps?

Ans. Currency swaps differ slightly from plain vanilla swaps or interest rate swaps. A currency swap is an agreement to exchange principal interest and fixed interest in one currency (i.e. the US Dollar) for principal interest and fixed interest in another currency (i.e, the Euro). Like interest rate swaps, whose lives can range from 2 years to beyond 10 years, currency swaps are a long-term hedging technique against interest rate risk but unlike interest rate swaps, currency swaps also manage risk borne from exchange rate fluctuations.

Ques.9. What is the interest rate future?

Ans. An Interest Rate Future (IRF) is a financial derivative with an interest-bearing instrument the underlying asset. Interest rate futures means a standardised interest rate contract traded on | recognised stock exchange to buy or sell a notional security or any other interest bearing instrument or an index of such instrument or interest rates at a specified future date, at a price determined at the time of contract. Interest rate futures are relatively new financial statements. It is one of the most successful¬† financial futures instrument in the world’s relatively new financial statement. It is one of the most successful financial futures instruments in the world. Interest rate futures trade in several maturities, currencies and different markets such as mortgages, federal issuance and short-term commercial paper. Interest rate futures tend to be highly liquid and are valued by the changing price of security, Future trading on interest-bearing securities started only in 1975, but the growth in this market has been tremendous.

Ques 10. Give the benefits of interest rate futures.

Ans. Interest rate futures are expected to provide the following benefits to market participants: 1. IRF will provide banks and financial institutions with an avenue for efficient asset-liability management.

  1. Fund managers and insurance companies can better manage asset allocation and investment using IRF
  2. IRF will also help individuals in efficient management of the household balance sheet.
  3. IRF will expand the scope of the financial markets in India and will further deepen the derivatives markets.
  4. Exchange-traded IRF are most transparent in terms of price discovery margining, risk management and settlement.
  5. IRF will enable corporates to hedge interest rate risk. Interest payments are one of the major parts of the expenditure for companies, volatility in interest rates could be better managed with the help of interest rate futures.

Ques.11. Give pay-off formula in fra.

Ans. The net payment made at the effective date is given by

where d = Discount factor.

  1. The fixed rate is the rate at which the contract is agreed.

2.The reference rate is typically Euribor or LIBOR.

  1. A is the day.count fraction, i.e. the portion of a year over which the rates are calculated, using the day count convention used in the money markets in the underlying currency. For EUR and USD this is generally the number of days divided by 360, for GBP it is the number of days divided by 365 days.
  2. The fixed rate and reference rate are rates over a period starting on the effective date and then paid at the end of the period (termination date). However, as the payment is already known at the beginning of the period, it is also paid at the beginning. This is why the discount factor is used in the denominator.

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