Question

32.

Which of the following statements is NOT an advantage of a swap transaction? A. It usually allows the company to achieve a lower cost of funds. B. It is used to hedge both interest rate risk and foreign exchange risk. C. It facilitates the restructuring of cash flows associated with existing borrowings. D. It transfers the credit risk to the counterparty. why d is not correct???

Answer 1

A) It usually allows the company to achieve a lower cost of funds.

Yes, this is true that swap turn into cost effective solutions for the borrowers. It lowers the the cost of borrowing as the borrower can take benefit of lower rate of interest. In interest rate swap, there is no exchange in the principal amount but only changes take place in the interest

For this, borrower can opt for any of the option out of these:

• He can swap from fixed to floating rate of interet.
• He can swap from floating to floating rate of interet.
• He can swap from fixed to fixed rate of interet.

B) It is used to hedge both interest rate risk and foreign exchange risk.    We know , there are two type of swap transactions Currency Swap Interest Swap In the case of Currency swap, borrowers take the arbitrage advantage/benefits because different markets have different exchange rate as well as interest rate also differs in those markets. Hence, the statement (B) is true. in this case (Currency Swap), both interest rate as well as principle amount get exchanged. Definitely this is the advantage of swap transaction. (C) It facilitates the restructuring of cash flows associated with existing borrowings. This is true that interest rate swap is the exchange of cash flows between the two parties. swaps reduces the future uncertainities as companies and borrowers use to hedge against hedge interest rates. Companies use this to play with their debt conditions by using it as financial tool. For eg, they payoff previous debt and get into debt conditions just swaping up the interest rates. D) It transfers the credit risk to the counterparty. The above statement is not entirely incorrect as getting into swaps comes with the uncertainity and there are chances that in case any of the party miss out or fails to meet the obligations. Credit default risk in the case of swap is the biggest risk observed while dealing with financial markets. There are also various studies done on the same concept to get the understanding of it. Also, it contributed much global credit crisis during 2008 . But, Yes this is definitely not the benefit in the case of swap.