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CA Final · Advanced Financial Management · Derivatives Analysis and Valuation

A CFO is comparing a plain vanilla interest rate swap with a fixed-for-fixed currency swap. Which statement is correct?

A currency swap deals in two currencies and normally exchanges principal at inception and re-exchanges it at maturity at the original rate. A plain vanilla interest rate swap uses the notional only to compute interest, with no principal exchange, and both swaps still carry counterparty credit risk.

  1. ABoth swaps always exchange the principal at inception and maturity.
  2. BNeither swap involves any counterparty credit risk, since only differences are settled.
  3. CA currency swap involves two currencies, and the principal is normally exchanged at the start and re-exchanged at maturity at the initial rate. An interest rate swap exchanges only interest flows on a notional principal.Correct
  4. DAn interest rate swap exchanges principal in two currencies, whereas a currency swap exchanges interest only.

Explanation

In a plain vanilla interest rate swap, the notional is used only to compute interest and is not exchanged. A currency swap involves two currencies, and the principal is normally exchanged at inception and re-exchanged at maturity at the original rate. Swaps carry credit risk, so the statement denying it is wrong.

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