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FRM Part I · FRM Exam Part I · Introduction to Derivatives

A bank has entered a pay-fixed interest rate swap with a corporate client, and has not hedged it. Market swap rates for the remaining life have since fallen well below the contracted fixed rate. Which statement about the bank's position is correct?

The swap has negative value to the bank. It pays a fixed rate that is now above the market swap rate, so it is a liability, and the corporate client, which holds the in-the-money position, is the party exposed to the bank's credit risk.

  1. AThe swap has positive value to the bank, so it faces credit exposure to the client
  2. BThe swap has negative value to the bank, so the client faces credit exposure to the bankCorrect
  3. CThe swap has zero value because swaps are always at par
  4. DThe swap has positive value to the bank because it receives floating

Explanation

The bank pays a fixed rate above the current market rate, so the swap is a liability to it (negative value). The client, which receives that above-market fixed rate, holds the asset and bears credit exposure to the bank. A swap is worth zero only at initiation, so C is wrong.

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