Swaps exercise Schweser notes

Hi all,

somebody who could help and explain me the following exercise?

The current U.S. dollar ($) to Canadian dollar (C$) exchange rate is 0.7. In a $1 million fixed-for-floating currency swap, the party that is entering the swap to hedge an existing exposure to a C$-denominated fixed-rate liability will: A. receive $1 million at the termination of the swap. B. pay a fixed rate based on the yield curve in the United States. C. receive a fixed rate based on the yield curve in Canada.

Thank you!

I guess it’s C, because if this guy has a CAD denominated fixed rate liability in real life, than he has to get a hedge where he receives this CAD fix rate.

That is correct, but could you explain better what do you mean with “has to get a hedge where he receives this CAD fix rate”.

I know that the fixed rate has to be derived from the curve in the relevant currncy of the fix rate, but I dont understand very well your explanation.

thank you

In order to hedge his CAD fixed liability he will enter a receive fixed CAD swap (paying floating USD) and the payoff he receives every settlement date will be based on the fixed swap rate which is determined by the CAD interest rate curve.

Maybe I did not understand your question:

  • Why C is the correct answer (I hope it is)?

Because the guy has to receive fixed CAD through the swap to hedge his fixed CAD liability

  • Why will his received fixed rate be based on the yield curve in Canada?

Because this is the way they determine the swap rate.

Answer C is right.

To be honest it’s easy (reading well the question which was my mistake) that the answer is C. It’s said that the party has to hedge the fixed CAD liability.

My problem is more in general, depending in which position I am, should I pay fixed and receive floating or viceversa?

If you have a fixed interest liability in real life (I mean you have a loan from a bank or issued a bond where you owe the bondholders fixed rate liability) you may want to have this exact fix rate income secured through the swap to annullate your payment.

Instead you might want to run the risk of paying the floating leg to your swap conterpart (probably beleiving in rates decresing).

If your liability is a floating rate then you would enter a swap as the pay fixed receive floating to hedge the floating rate liability in the real life.

If you have an asset not a liability then again just consider what inflow or outflow you want to hedge and you seek a hedge transaction that secures for you that inflow or outflow (being fixed or floating depending on the individual case).

Honestly I can’t explain better. I’m not a native English speaker but I tried to be as clear as I could.

Hope you understand.

Draw a swap diagram; it’ll help immensely.

1 Like

Thank you for your explanation.
I have one thing that I don’t understand.
Since both parties will exchange at beginning of the swap, in this case CAD for USD, which means the party who wants to hedge already has the CAD in hand to pay for the CAD fixed-rate liability.
Why don’t just make the payment using the CAD in hand instead of entering the swap.

Hi. I’m struggling to identify in this type of questions who is the fixed rate payer or received of USD or CAD… it is really confusing… Any advice?

The liability is in C$ and mentioned in Fixed rate. The borrower needs to serve the debt. The risks are two prongs ( in general, not necessarily here).

  1. The fluctuation of C$ to US$ exchange rate.

  2. The fixed rate may become too expensive if the flowing rate dips.

  3. Since the principals are exchanged with the swap counterparts at the beginning hence the C$ to US$ fluctuation is irrelevant as at the end of swap tenor the principals will be reexchanged at face value.

  4. For the second part, the borrower enters into floating for fixed interest rate swap of the principal ( of course with the same counterparts) where (s)he pays floating rate and receives fixed rate. If her a riti pation is correct then she has technically funded a fixed rate liability into a much cheaper floating rate liability.

Hope it is clear now.