Practice: Pricing and Valuation of Interest Rates and Other Swaps

Derivatives. 13 question(s) in this unit's pool (2 above the exam). Free up to ten a day; the coach picks which ones based on what you have already answered and when each is next due.

DerivativesPricing and Valuation of Interest Rates and Other Swaps
Your state on this unit Not started

Read the lesson for this unit · Back to your map

Today's practice

Pick an answer, say how sure you are, then reveal. Every wrong choice gets its own explanation. Questions you have already answered correctly and confidently stay out of the way until they are due for review again.

Question 1Exam level

Two parties enter a plain vanilla interest rate swap. Party A pays a fixed rate of 5% annually and Party B pays the floating rate. The notional principal is $10 million. At the first settlement date, the floating rate (SOFR) has reset to 6%. Which of the following best describes the net settlement payment?

How sure are you?

Correct: B. The correct answer is Party B pays Party A $100,000.
A. You might confuse which party is the 'payer'. They think 'fixed-rate payer' means the party receiving fixed payments. Fixed-rate payer = the party obligated to PAY fixed. When floating rises above fixed, the floating-rate payer owes more and makes the net payment.
C. You might divide the difference by 2, confusing semi-annual with annual settlement. The problem specifies annual settlement, so the full annual rate difference applies. No division by 2.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 2Exam level

In an interest rate swap, the notional principal is most likely described as:

How sure are you?

Correct: B. The correct answer is The amount used to calculate periodic interest payments but not exchanged.
A. Currency swaps DO exchange notional principal. You might generalize this to all swaps. IRS notional is not exchanged because both legs are in the same currency. There is no currency risk requiring principal transfer.
C. Sounds financially sophisticated and relates to swap valuation. This describes the swap's market value, not the notional principal itself. The notional is a fixed reference amount, not a present value.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 3Exam level

A company has issued floating-rate debt tied to SOFR + 150 bps and is concerned that interest rates will rise significantly. The company enters a pay-fixed, receive-floating interest rate swap. Which of the following describes the company's effective borrowing cost after the swap, most likely?

How sure are you?

Correct: C. The correct answer is The company has converted its floating-rate debt to synthetic fixed-rate debt at a cost equal to the fixed swap rate plus 150 bps.
A. Partially true. The company does have fixed-rate exposure. But 'benefits if SOFR rises' implies a speculative gain, which misframes the hedging purpose. If SOFR rises, the swap gain offsets the higher debt cost. The company is hedged, not speculating for a profit.
B. The underlying debt contract itself does not change. Literally true, but misleads about the combined position. The combined position (debt + swap) creates a synthetic fixed rate. The swap overlay changes the effective exposure even though the debt contract is unmodified.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 4Exam level

Which of the following most likely explains why a plain vanilla interest rate swap has zero value at initiation?

How sure are you?

Correct: B. The correct answer is Because the fixed rate is set so that the present value of fixed payments equals the present value of expected floating payments.
A. Notional not being exchanged sounds like a reason there is no value to the instrument. The absence of notional exchange is unrelated to valuation. Value depends on the relationship between PVs of each leg, not on whether principal moves.
C. Financial regulation does require margin and collateral. Sounds plausible as a rule-based answer. The zero-value-at-initiation is a no-arbitrage economic condition, not a regulatory requirement. The exam tests understanding of the economic logic.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 5Harder

Party X enters a 2-year interest rate swap as the fixed-rate payer at 4%. Six months later, market interest rates have risen so that the fixed rate on a comparable new 1.5-year swap is now 5%. The value of Party X's swap position is most likely:

How sure are you?

Correct: C. The correct answer is Positive, because Party X locked in a below-market fixed rate relative to current market.
A. Paying 'below-market' sounds like a disadvantage. A language trap. For the PAYER of the below-market rate, this is an ADVANTAGE. They pay less than the current market requires. 'Below-market fixed payment' = favorable obligation.
B. The zero-value-at-initiation rule is overgeneralized to all points in the swap's life. Zero value only applies at initiation. Once rates move, one side of the swap gains value and the other loses it. The zero-value rule is an initiation condition only.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 6Exam level

In a currency swap between a US company and a German company, compared to a plain vanilla interest rate swap, the treatment of notional principal is most likely described as:

How sure are you?

Correct: C. The correct answer is Exchanged at both initiation and maturity in the currency swap but not in the interest rate swap.
A. Students memorize 'notional is not exchanged' from IRS and apply it universally to all swap types. This is true ONLY for IRS. Currency swaps must exchange principal because the two currencies have different values and create exchange rate exposure that requires actual transfer.
B. Reversing the true answer. A classic CFA distractor technique. IRS notional is not exchanged. Currency swap notional IS exchanged. The opposite of this answer.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 7Exam level

A US company wants to borrow in euros to fund its European subsidiary but can borrow more cheaply in US dollars. A German company faces the mirror-image situation. They enter a currency swap. Which of the following most likely accurately describes what happens at swap initiation?

How sure are you?

Correct: B. The correct answer is The US company receives euros and pays an equivalent amount of dollars to the German company.
A. You might apply IRS logic (no principal exchange) to currency swaps. Currency swaps exchange principal precisely because the two amounts are in different currencies with real exchange rate risk.
C. Describes a cross-currency basis swap variant, not a standard currency swap. Standard currency swaps exchange both principal AND interest in different currencies. The structure in C is a more complex instrument not tested at Level 1.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 8Exam level

In a plain vanilla interest rate swap with semi-annual payments, the fixed rate is 4.5% per year and the floating rate resets to 5.2% at the start of the period. The notional principal is $20 million. The net payment at this settlement date is CLOSEST to:

How sure are you?

Correct: B. The correct answer is $70,000 paid by the floating-rate payer to the fixed-rate payer.
A. Correct dollar amount, wrong direction. You might get the number right but reverse the payment direction. Floating-rate payer owes MORE (5.2% > 4.5%), so they PAY the net difference to the fixed-rate payer, not the reverse.
C. You might forget to halve the annual rates for semi-annual frequency. Use annual rates without dividing by 2. Semi-annual payment uses half the annual rate. Using full annual rates doubles the result incorrectly to $140,000.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 9Harder

A floating-rate payer in a plain vanilla interest rate swap will most likely experience a gain on the swap position if:

How sure are you?

Correct: A. The correct answer is Interest rates decline below the fixed swap rate over the life of the swap.
B. Rising rates sounds like it benefits derivative holders broadly; also confuses floating-rate payer with fixed-rate payer. If rates rise, the floating-rate PAYER owes more (pays expensive floating, receives fixed). Rising rates benefit the FIXED-rate payer (who receives the now-higher floating).
C. Yield curve shape analysis sounds advanced and sophisticated. Swap payments depend on short-end floating rates like SOFR. A steepening curve with unchanged short end does not change near-term floating payments materially.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 10Exam level

Which of the following is MOST accurate regarding counterparty credit risk in an interest rate swap compared to an exchange-traded interest rate futures contract?

How sure are you?

Correct: B. The correct answer is Swaps have higher counterparty credit risk because they are OTC contracts without the same central clearinghouse guarantee as exchange-traded futures.
A. No notional exchange sounds like less money is at risk overall. Credit risk is about the MARK-TO-MARKET value of the swap, not the notional. If a counterparty defaults when your swap has positive value, you lose that mark-to-market gain.
C. Zero-sum is a true property of derivatives. But does not equate credit risk across instrument types. Zero-sum means every gain equals a counterparty loss. It says nothing about the probability of counterparty default or the settlement guarantee mechanism.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 11Harder

A US corporation issues 5-year fixed-rate bonds denominated in euros to fund its European expansion. The company wants to eliminate currency risk on both the coupon payments and the principal repayment. The MOST appropriate derivative instrument is:

How sure are you?

Correct: B. The correct answer is A currency swap exchanging EUR interest and principal payments for USD payments.
A. The company has a fixed-rate bond. An IRS sounds relevant to fixed income. An IRS only swaps fixed vs floating in the SAME currency. It does nothing to address the USD/EUR exchange rate risk, which is the stated problem.
C. A series of forwards could theoretically hedge each coupon cash flow. A series of forwards is operationally complex, does not package the principal repayment cleanly, and is precisely what a currency swap replaces with a single contract. The currency swap is more efficient and comprehensive.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 12Above the exam

A company enters a 2-year interest rate swap, paying a fixed rate and receiving floating (SOFR), to hedge floating-rate debt. One year into the swap, interest rates have risen significantly since initiation. Combining how swap value evolves with changing rates and the perspective of the fixed-rate payer, the value of this swap TO THE COMPANY (the fixed-rate payer) at this point is most likely:

How sure are you?

Correct: B. A swap has zero value to both parties ONLY at initiation (when the fixed rate is set so the present values of the fixed and floating legs are equal). As market rates change over the swap's life, its value shifts: since the fixed-rate PAYER benefits when rates RISE (their fixed obligation becomes relatively cheaper compared to the now-higher floating payments they receive), a rate increase since initiation makes the swap valuable TO the fixed-rate payer (the company here), and correspondingly creates a matching loss in value for the fixed-rate receiver on the other side.
A. Rising rates do not hurt every party to a swap equally; the effect depends on which side of the swap a party is on. The FIXED-RATE PAYER specifically benefits from rising rates, since receiving a higher floating rate while paying a fixed rate locked in earlier becomes more favorable, not less.
C. A swap only has zero value at the moment of initiation, when its terms are set to make the two legs' present values equal; once time passes and market rates move away from the original fixed rate, the swap's value to each party generally becomes nonzero.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps

Question 13Above the exam

A dealer is the fixed-rate receiver on an interest rate swap with a notional principal of $10 million. Combining the mechanics of periodic net settlement with the fact that only the difference between the fixed and floating legs is exchanged, if the fixed rate is 4% and the floating rate resets at 5.5% for a given period (with a full-year day count for simplicity), the dealer should most likely:

How sure are you?

Correct: B. Interest rate swaps settle on a NET basis each period: only the difference between what each side owes is actually exchanged. As the fixed-rate RECEIVER, the dealer is owed 4% x $10 million = $400,000 but owes the floating amount, 5.5% x $10 million = $550,000; on a net basis, the dealer must PAY the $150,000 difference ($550,000 - $400,000), since the floating leg exceeds the fixed leg this period.
A. Swap payments are settled NET, not gross; the dealer does not simply receive the full fixed amount owed to them without also netting out the larger floating amount they owe, which flips the direction of the actual cash flow entirely once netted.
C. Standard interest rate swaps settle PERIODICALLY (e.g., quarterly or semi-annually) over the life of the swap, not only at maturity; periodic net settlement is a defining mechanical feature of how swaps actually function.

Unit: pricing-and-valuation-of-interest-rates-and-other-swaps