15. Rate-Capped Swaps- Bull and Finch Company want a fixed-for-floating swap. It

Question

15. Rate-Capped Swaps- Bull and Finch Company want a fixed-for-floating swap. It expects interest rates to rise far above the fixed rate that it would pay and to remain very high until the swap maturity date. Should it consider negotiating for a rate-capped swap with the cap set at 2 percentage points above the fixed rate? Explain.<?xml:namespace prefix = o ns = "urn:schemas-microsoft-com:office:office" />

16. Forward Swaps- Rider Company negotiates a forward swap, to begin two years from now, in which it will swap fixed payments for floating-rate payments. What will be the effect on Rider if interest rates rise substantially over the next two years? That is, would Rider be better off using this forward swap than if it had simply waited two years before negotiating the swap? Explain.

19. Credit Default Swaps- Credit default swaps were once viewed as a great innovation for making mortgage markets more stable. Recently, however, the swaps have been criticized for making the credit crisis worse. Why?

Explanation / Answer

15.

Bull and Finch should not consider the rate-capped swap because it would restrict the potential interest payments received. Based on its expectations, it would forgo large payments with a cap, which would more than offset the up-front fee received for agreeing to a cap.

16.

Rider would have been better off with the forward swap, because the fixed rate specified in the forward swap would be lower than the fixed rate specified two years later (since the fixed rate negotiated at any time will be somewhat dependent on prevailing rates at that time). By using a forward swap, Rider would have been able to lock in a lower rate on its fixed outflow payments in the swap arrangement.

19.

Credit default swaps protect securities against default, but the protection is only as strong as the seller of the swaps. Some financial institutions that sold credit default swaps were subject to failure, which means that all the securities that they were protecting might not be protected. Therefore, the credit default swaps encouraged some investors to take the risk of buying risky mortgage-backed securities that they thought were backed by the swap, which led to even more risk when considering that the sellers of swaps might default.

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