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Fundamentals of Multinational Finance e Moffett Interbank Rates

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					Fundamentals of Multinational Finance, 3e (Moffett)
Chapter 15 Interest Rate and Currency Swaps

15.1 Multiple Choice and True/False Questions
      1) The single largest interest rate risk of a firm is ________.
           A) interest sensitive securities
           B) debt service
           C) dividend payments
           D) accounts payable
         Answer: B
        Topic: Interest Rate Risk
        Skill: Recognition

      2) A ________ rate is the rate of interest used in a standardized quotation, loan agreement, or
         financial derivative valuation.
            A) reference rate
            B) central rate
            C) benchmark rate
            D) none of the above
         Answer: A
        Topic: Reference Rate
        Skill: Recognition

      3) The most widely used reference rate for standardized quotations, loan agreements, or
         financial derivative valuations is the ________.
            A) Federal Reserve Discount rate
            B) federal funds rate
            C) LIBOR
            D) one-year U.S. Treasury Bill
         Answer: C
        Topic: LIBOR
        Skill: Recognition

      4) LIBOR is an acronym for
           A) Latest Interest Being Offered Rate.
           B) Large International Bank Offered Rate.
           C) Least Interest Bearing: Official Rate.
           D) London Interbank Offered Rate.
         Answer: D
        Topic: LIBOR
        Skill: Recognition

      5) Corporate treasury departments have traditionally been
           A) profit centers.
           B) centers of aggressive profit taking.
           C) service or cost centers.
           D) none of the above.
         Answer: C
        Topic: Corporate Treasury Departments
        Skill: Recognition
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 6) As a management tool, a ________ is a rule, but a ________ is an objective.
     A) policy; goal
      B) goal; policy
      C) FIBOR; GIBOR
      D) none of the above
    Answer: A
   Topic: Policies and Goals
   Skill: Conceptual

 7) The following would be an example of a policy, not a goal.
      A) Management shall minimize the firm's overall weighted average cost of capital.
      B) Management shall maximize shareholder's wealth.
      C) Management will not write uncovered options.
      D) Management will hire only happy employees.
    Answer: C
   Topic: Policies and Goals
   Skill: Recognition

 8) Which of the following is NOT true regarding a corporate policy?
     A) A policy is intended to limit or restrict management actions.
      B) Policies make management decision-making more difficult in potentially harmful
         situations.
     C) A policy is intended to restrict some subjective management decision-making.
     D) A policy is intended to establish operating guidelines independently of staff.
    Answer: B
   Topic: Policies and Goals
   Skill: Conceptual

 9) Historically, interest rate movements have shown less variability and greater stability than
    exchange rate movements.
    Answer: TRUE
   Topic: Interest Rate Risk
   Skill: Recognition

10) 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.
    Answer: FALSE
   Topic: Interest Rate Risk
   Skill: Conceptual




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      11) ________ is the possibility that the borrower's creditworthiness is reclassified by the lender
          at the time of renewing credit. ________ is the risk of changes in interest rates charged at the
          time a financial contract rate is set.
             A) Credit risk; Interest rate risk
             B) Repricing risk; Credit risk
             C) Interest rate risk; Credit risk
             D) Credit risk; Repricing risk
          Answer: D
          Topic: Credit and Repricing Risk
          Skill: Recognition

Instruction 15.1:
For 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%.

      12) Refer to Instruction 15.1. Choosing strategy #1 will
            A) guarantee the lowest average annual rate over the next three years.
            B) eliminate credit risk but retain repricing risk.
            C) maintain the possibility of lower interest costs, but maximizes the combined credit and
               repricing risks.
            D) preclude the possibility of sharing in lower interest rates over the three-year period.
          Answer: D
          Topic: Credit and Repricing Risk
          Skill: Conceptual

      13) Refer to Instruction 15.1. Choosing strategy #2 will
            A) guarantee the lowest average annual rate over the next three years.
            B) eliminate credit risk but retain repricing risk.
            C) maintain the possibility of lower interest costs, but maximizes the combined credit and
               repricing risks.
            D) preclude the possibility of sharing in lower interest rates over the three-year period.
          Answer: B
          Topic: Credit and Repricing Risk
          Skill: Conceptual

      14) Refer to Instruction 15.1. Choosing strategy #3 will
            A) guarantee the lowest average annual rate over the next three years.
            B) eliminate credit risk but retain repricing risk.
            C) maintain the possibility of lower interest costs, but maximizes the combined credit and
               repricing risks.
            D) preclude the possibility of sharing in lower interest rates over the three-year period.
          Answer: C
          Topic: Credit and Repricing Risk
          Skill: Conceptual

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15) Refer to Instruction 15.1. Which strategy (strategies) will eliminate credit risk?
      A) Strategy #1
      B) Strategy #2
      C) Strategy #3
      D) Strategy #1 and #2
    Answer: D
   Topic: Credit and Repricing Risk
   Skill: Conceptual

16) Refer to Instruction 15.1. 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.)
      A) Strategy #3
      B) Strategy #2
      C) Strategy #1
      D) Strategy #1, #2, or #3, you are indifferent among the choices.
    Answer: A
   Topic: Credit and Repricing Risk
   Skill: Conceptual

17) Refer to Instruction 15.1. The risk of strategy #1 is that interest rates might go down or that
    your credit rating might improve. The risk of strategy #2 is (Assume your firm is borrowing
    money.)
      A) that interest rates might go down or that your credit rating might improve.
      B) that interest rates might go up or that your credit rating might improve.
      C) that interest rates might go up or that your credit rating might get worse.
      D) none of the above.
    Answer: B
   Topic: Credit and Repricing Risk
   Skill: Conceptual

18) Refer to Instruction 15.1. The risk of strategy #1 is that interest rates might go down or that
    your credit rating might improve. The risk of strategy #3 is (Assume your firm is borrowing
    money.)
      A) that interest rates might go down or that your credit rating might improve.
      B) that interest rates might go up or that your credit rating might improve.
      C) that interest rates might go up or that your credit rating might get worse.
      D) none of the above.
    Answer: C
   Topic: Credit and Repricing Risk
   Skill: Conceptual




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19) Refer to Instruction 15.1. After the fact, under which set of circumstances would you prefer
    strategy #1? (Assume your firm is borrowing money.)
       A) Your credit rating stayed the same and interest rates went up.
       B) Your credit rating stayed the same and interest rates went down.
       C) Your credit rating improved and interest rates went down.
       D) Not enough information to make a judgment.
    Answer: A
   Topic: Credit and Repricing Risk
   Skill: Conceptual

20) Refer to Instruction 15.1. After the fact, under which set of circumstances would you prefer
    strategy #2? (Assume your firm is borrowing money.)
       A) Your credit rating stayed the same and interest rates went up.
       B) Your credit rating stayed the same and interest rates went down.
       C) Your credit rating improved and interest rates went down.
       D) Not enough information to make a judgment.
    Answer: B
   Topic: Credit and Repricing Risk
   Skill: Conceptual

21) Refer to Instruction 15.1. After the fact, under which set of circumstances would you prefer
    strategy #3? (Assume your firm is borrowing money.)
       A) Your credit rating stayed the same and interest rates went up.
       B) Your credit rating stayed the same and interest rates went down.
       C) Your credit rating improved and interest rates went down.
       D) Not enough information to make a judgment.
    Answer: C
   Topic: Credit and Repricing Risk
   Skill: Conceptual




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TABLE 15.1
Use the information for Polaris Corporation to answer following question(s).

Polaris is taking out a $5,000,000 two-year loan at a variable rate of LIBOR plus 1.00%. The LIBOR rate
will be reset each year at an agreed upon date. The current LIBOR rate is 4.00% per year. The loan has an
upfront fee of 2.00%




      22) Refer to Table 15.1. What is the all-in-cost (i.e., the internal rate of return) of the Polaris loan
          including the LIBOR rate, fixed spread and upfront fee?
            A) 4.00%
             B) 5.00%
            C) 5.53%
            D) 6.09%
          Answer: D
          Topic: All-in-Cost
          Skill: Analytical

      23) Refer Table 15.1. What portion of the cost of the loan is at risk of changing?
            A) the LIBOR rate
            B) the spread
            C) the upfront fee
            D) all of the above
          Answer: A
          Topic: Variable Rate Loan Agreements
          Skill: Conceptual

      24) Refer Table 15.1. If the LIBOR rate jumps to 5.00% after the first year what will be the all-in-
          cost (i.e. the internal rate of return) for Polaris for the entire loan?
            A) 5.25%
            B) 5.50%
            C) 6.09%
            D) 6.58%
          Answer: D
          Topic: All-in-Cost
          Skill: Analytical




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25) Refer Table 15.1. If the LIBOR rate falls to 3.00% after the first year what will be the all-in-
    cost (i.e. the internal rate of return) for Polaris for the entire loan?
      A) 4.00%
      B) 4.50%
      C) 5.25%
      D) 5.60%
    Answer: D
   Topic: All-in-Cost
   Skill: Analytical

26) Refer Table 15.1. Polaris could have locked in the future interest rate payments by using
      A) a forward rate agreement.
      B) an interest rate future.
      C) an interest rate swap.
      D) any of the above.
    Answer: D
   Topic: Hedging
   Skill: Recognition

27) An interbank-traded contract to buy or sell interest rate payments on a notional principal is
    called a/an ________.
      A) forward rate agreement
       B) interest rate future
      C) interest rate swap
      D) none of the above
    Answer: A
   Topic: Forward Rate Agreement
   Skill: Recognition

28) A/an ________ is a contract to lock in today interest rates over a given period of time.
      A) forward rate agreement
      B) interest rate future
      C) interest rate swap
      D) none of the above
    Answer: B
   Topic: Interest Rate Futures
   Skill: Recognition

29) An agreement to exchange interest payments based on a fixed payment for those based on a
    variable rate (or vice versa) is known as a/an ________.
      A) forward rate agreement
      B) interest rate future
      C) interest rate swap
      D) none of the above
    Answer: C
   Topic: Interest Rate Swaps
   Skill: Recognition




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30) Interest rate futures are relatively unpopular among financial managers because of their
    relative illiquidity and their difficulty of use.
    Answer: FALSE
   Topic: Interest Rate Futures
   Skill: Recognition

31) A basis point is ________.
      A) 1.00%
      B) 0.10%
      C) 0.01%
      D) none of the above
    Answer: C
   Topic: Basis Points
   Skill: Recognition

32) A basis point is one-tenth of one percent.
    Answer: FALSE
   Topic: Basis Points
   Skill: Recognition

33) The financial manager of a firm has a variable rate loan outstanding. If she wishes to protect
    the firm against an unfavorable increase in interest rates she could
      A) sell an interest rate futures contract of a similar maturity to the loan.
       B) buy an interest rate futures contract of a similar maturity to the loan.
      C) swap the adjustable rate loan for another of a different maturity.
      D) none of the above.
    Answer: A
   Topic: Interest Rate Futures
   Skill: Conceptual

34) An agreement to swap a fixed interest payment for a floating interest payment would be
    considered a/an ________.
      A) currency swap
      B) forward swap
      C) interest rate swap
      D) none of the above
    Answer: C
   Topic: Interest Rate Swaps
   Skill: Recognition

35) An agreement to swap the currencies of a debt service obligation would be termed a/an
    ________.
      A) currency swap
      B) forward swap
      C) interest rate swap
      D) none of the above
    Answer: A
   Topic: Currency Swap
   Skill: Recognition




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36) Which of the following would be considered an example of a currency swap?
     A) exchanging a dollar interest obligation for a British pound obligation
      B) exchanging a eurodollar interest obligation for a dollar obligation
     C) exchanging a eurodollar interest obligation for a British pound obligation
     D) All of the above are example of a currency swap.
    Answer: D
   Topic: Currency Swap
   Skill: Recognition

37) A swap agreement may involve currencies or interest rates, but never both.
    Answer: FALSE
   Topic: Swap Agreement
   Skill: Conceptual

38) A firm with fixed-rate debt that expects interest rates to fall may engage in a swap
    agreement to
      A) pay fixed-rate interest and receive floating rate interest.
      B) pay floating rate and receive fixed rate.
      C) pay fixed rate and receive fixed rate.
      D) pay floating rate and receive floating rate.
    Answer: B
   Topic: Swap Agreement
   Skill: Conceptual

39) A firm with variable-rate debt that expects interest rates to rise may engage in a swap
    agreement to
      A) pay fixed-rate interest and receive floating rate interest.
      B) pay floating rate and receive fixed rate.
      C) pay fixed rate and receive fixed rate.
      D) pay floating rate and receive floating rate.
    Answer: A
   Topic: Swap Agreement
   Skill: Conceptual

40) The interest rate swap strategy of a firm with fixed rate debt and that expects rates to go up
    is to
       A) do nothing.
        B) pay floating and receive fixed.
       C) receive floating and pay fixed.
       D) none of the above.
    Answer: A
   Topic: Interest Rate Swaps
   Skill: Conceptual




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41) A preferred interest rate swap strategy for a firm with variable-rate debt and that expects
    rates to go up is to
      A) do nothing.
       B) pay floating and receive fixed.
       C) pay floating and pay fixed.
      D) none of the above.
    Answer: D
    Topic: Interest Rate Swaps
    Skill: Conceptual

42) Some of the world's largest and most financially sound firms may borrow at variable rates
    less than LIBOR.
    Answer: TRUE
    Topic: LIBOR
    Skill: Recognition

43) Polaris Inc. has a significant amount of bonds outstanding denominated in yen because of
    the attractive variable rate available to the firm in yen when the loan was made. However,
    Polaris does not have significant receivables in yen. Options available to Polaris to consider
    the risk of such a loan include which one of the following?
      A) doing nothing to offset the need for yen
       B) developing a currency swap of paying dollars and receiving yen
      C) developing an interest rate swap of receiving a variable rate while paying a fixed rate
      D) Polaris may engage in any of the strategies to a varying degree of effectiveness.
    Answer: D
    Topic: Currency Swaps
    Skill: Conceptual

44) 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 ________.
      A) interest rate risk
      B) credit risk
      C) counterparty risk
      D) clearinghouse risk
    Answer: C
    Topic: Counterparty Risk
    Skill: Recognition

45) Counterparty risk is
      A) present only with exchange-traded options.
      B) based on the notional amount of the contract.
      C) the risk of loss if the other party to a financial contract fails to honor its obligation.
      D) eliminated by the use of insurance funds.
    Answer: C
    Topic: Counterparty Risk
    Skill: Recognition




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46) Counterparty risk is greater for exchange-traded derivatives than for over-the-counter
    derivatives.
    Answer: FALSE
   Topic: Counterparty Risk
   Skill: Recognition

47) Which of the following would an MNE NOT want to do?
     A) Pay a very low fixed rate of interest in the long term.
      B) Swap into a foreign currency payment that is falling in value.
     C) Swap into a floating interest rate receivable just prior to interest rates going up.
     D) Swap into a fixed interest rate receivable just prior to interest rates going up.
    Answer: C
   Topic: Swap Strategies
   Skill: Conceptual

48) Outright techniques of interest rate risk management do not include which of the following?
     A) forward rate agreements
      B) interest rate futures
     C) currency swaps
     D) cap, floors, and collars
    Answer: D
   Topic: Swap Strategies
   Skill: Recognition

49) Which of the following is NOT true?
     A) A plain vanilla swap allows a firm to change the currency of denomination of debt
         service.
      B) A swap does not change the legal liabilities of existing debt obligations of MNEs.
     C) The swap market does not differentiate participants on the basis of credit quality.
     D) All of the above are true.
    Answer: D
   Topic: Plain Vanilla Swaps
   Skill: Conceptual

50) A combined position of selling one currency forward at one maturity while buying the same
    currency forward at a different maturity to lock in a future interest rate in the foreign
    currency is a/an
      A) forward swap.
      B) forward rate agreement.
      C) interest rate future.
      D) currency and interest rate swap.
    Answer: A
   Topic: Currency and Interest Rate Swaps
   Skill: Recognition




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      51) Cross currency swaps typically have larger swings in total value than "plain vanilla" interest
          rate swaps because
            A) cross currency swaps exchange principal as well as interest payments.
             B) interest rate movements are more volatile than currency movements.
             C) interest rate swap agreements do not allow, contractually, large movements from par.
            D) all of the above.
          Answer: D
         Topic: Cross Currency Swaps
         Skill: Conceptual

      52) A U.S.-based firm with dollar denominated debt, but continuing sales denominated in
          Japanese yen, could
            A) purchase an interest rate cap agreement.
             B) enter into a swap agreement to swap dollar interest for Japanese interest payments.
            C) purchase a series of rolling futures contracts to buy Japanese yen forward.
            D) all of the above.
          Answer: B
         Topic: Swap Agreement
         Skill: Conceptual

      53) A firm entering into a currency or interest rate swap agreement is relieved of the ultimate
          responsibility for the timely servicing of its own debt obligations.
          Answer: FALSE
         Topic: Servicing Debt Obligations
         Skill: Recognition

TABLE 15.2
Use the information to answer following question(s).




      54) Refer to Table 15.2. For a swap agreement structured by Barclay's to benefit both Shell and
          Merck, which of the following must be true?
            A) Barclay's must be willing to lend to Merck at a fixed rate of less than 7.50% and to Shell
               at a variable rate of less than LIBOR + 1/2%.
            B) Barclay's must be willing to lend to Shell at a fixed rate of less than 8.00% and to Merck
               at a variable rate of less than LIBOR + 1/2%.
            C) Barclay's must be willing to lend to Merck at a variable rate of less than 8.00% and to
               Shell at a fixed rate of less than LIBOR + 1/2%.
            D) Barclay's must be willing to lend to Merck at a fixed rate of greater than 8.00% and to
               Shell at a variable rate of greater than LIBOR + 1/2%.
          Answer: A
         Topic: Interest Rate Swaps
         Skill: Analytical




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55) Refer to Table 15.2. Which of the following swap agreements could work for Shell and Merck
    with Barclay's as the facilitating bank?
      A) Merck borrows at a fixed rate of 6% and then enters into "receive fixed, pay floating"
         interest rate swap with Barclay's. Shell borrows money at a variable rate of LIBOR + 1%
         and then enters into "receive variable, pay fixed" interest rate swap with Barclay's.
      B) Shell borrows at a fixed rate of 6% and then enters into a "receive variable, pay fixed"
         interest rate swap with Barclay's. Merck borrows money at a variable rate of LIBOR +
         1% and then enters into "receive fixed, pay floating" interest rate swap with Barclay's.
      C) Shell borrows at a fixed rate of 6% and then enters into "receive fixed, pay floating"
         interest rate swap with Barclay's. Merck borrows money at a variable rate of LIBOR +
         1% and then enters into "receive variable, pay fixed" interest rate swap with Barclay's.
      D) None of the above would satisfy both Shell and Merck.
    Answer: C
   Topic: Interest Rate Swaps
   Skill: Analytical

56) Refer to Table 15.2. Which of the following are viable rates for the swap agreements with
    Barclay's Bank by Shell and Merck?
      A) Shell borrows at a variable rate of LIBOR + 1% and enters into a swap with Barclay's
         that pays Shell variable LIBOR + 1% while Shell pays Barclay's fixed 7 1/4%. At the
         same time, Merck borrows at the fixed rate of 6.00% and enters into a swap agreement
         with Barclay's that pays Merck 6.00% while Merck pays Barclay's LIBOR plus 1/4%.
      B) Merck borrows at a variable rate of LIBOR + 1% and enters into a swap with Barclay's
         that pays Merck variable LIBOR + 1% while Merck pays Barclay's fixed 7 1/4%. At the
         same time, Shell borrows at the fixed rate of 6.00% and enters into a swap agreement
         with Barclay's that pays Shell 6.00% while Shell pays Barclay's LIBOR plus 1/4%.
      C) Merck borrows at a fixed rate of 7.5% and enters into a swap with Barclay's that pays
         Merck variable LIBOR + 1% while Merck pays Barclay's fixed 7 1/4%. At the same time,
         Shell borrows at the variable rate of LIBOR + 1/2% and enters into a swap agreement
         with Barclay's that pays Shell 6.00% while Shell pays Barclay's LIBOR plus 1/4%.
      D) Merck borrows at a variable rate of LIBOR + 1% and enters into a swap with Barclay's
         that pays Merck a fixed rate of 7% while Merck pays Barclay's variable LIBOR +1%. At
         the same time, Shell borrows at the fixed rate of 6.00% and enters into a swap
         agreement with Barclay's that pays Shell 6.00% while Shell pays Barclay's LIBOR plus
         1/4%.
    Answer: B
   Topic: Interest Rate Swaps
   Skill: Analytical

57) Molson Brewery, a Canadian company wishes to borrow $1,000,000 for 12 weeks. A rate of
    6.00% per annum is quoted by lenders in both New York and London using, respectively,
    international and British definitions of interest. From which source should Molson borrow
    other things equal? What is Molson's total interest charge from the selected source?
      A) New York; $14,000
       B) New York; $13,808
       C) London; $14,000
      D) London; $13,808
    Answer: D
   Topic: Day Count Conventions
   Skill: Analytical

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    58) Graham Investments must pay floating rate interest 6 months from now. The firm can lock
        in the rate by buying an interest rate futures contract. Interest rate futures for 6 months from
        today are currently settled at 95.03 for a yield of 4.97% per annum. If the floating interest rate
        6 months from now is 6%, how much did Graham gain or lose?
          A) Loss; 1.03%
           B) Loss; 2.06%
           C) Gain; 1.03%
          D) Gain; 2.06%
        Answer: C
       Topic: Interest Rate Futures
       Skill: Analytical

    59) OTC interest rate derivative daily turnover has declined over the last decade in part due to
        the threat of terrorism and high energy prices.
        Answer: FALSE
       Topic: Foreign Exchange Turnover
       Skill: Recognition

    60) The largest amount of daily trading in the foreign exchange derivatives market occurs in
        which of the following types of securities?
          A) swaps
          B) FRAs
          C) options
          D) These three choices have equal daily trading volumes.
        Answer: A
       Topic: Foreign Exchange Turnover
       Skill: Recognition

    61) Over the last decade floating-rate notes have decreased in both total volume and percentage
        of total dollar-denominated bond issuances.
        Answer: FALSE
       Topic: Floating-rate notes
       Skill: Recognition


15.2 Essay Questions
     1) 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.
        Answer: Sell a futures position. If rates change the payoff from the futures position offsets the
                  gain or loss on the variable rate debt obligation. Swap a variable rate debt obligation
                  for a fixed futures payable contract.

     2) How does counterparty risk influence a firm's decision to trade exchange-traded derivatives
        rather than over-the-counter derivatives?
        Answer: With exchange-traded derivatives, the exchange is the clearinghouse. Thus, firms do
                 not need to worry about the other party making good on its obligations and it is easier
                 to trade the derivative products.




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