Section A

Two companies, Firm A and Firm B, enter into an interest rate swap. Firm A has a comparative advantage in borrowing at fixed rates, while Firm B has a comparative advantage in borrowing at floating rates.

Which of the following risks is introduced specifically by entering into this swap agreement?

Answer options:

Translation risk

Counterparty risk

Basis risk

Liquidity risk

How to approach this question

Consider what happens if the other company in the swap goes bankrupt.

Full Answer

B.Counterparty risk✓ Correct

An interest rate swap is an agreement between two parties to exchange interest rate cash flows. Because it is a private contract (Over-The-Counter), it introduces Counterparty Risk—the risk that the other party will default on their obligation to make the swap payments. If Firm B defaults, Firm A will no longer receive the payments needed to cover its underlying loan obligations.

Common mistakes

Selecting basis risk. While basis risk exists in swaps, counterparty risk is the most direct and severe risk introduced by the bilateral agreement.

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