Chartered Financial Analyst (CFA) Practice Exam Level 2

How is Swap Value defined at initiation?

1. Equal to the market value of the bonds involved

2. Zero

3. Equal to the present value of future cash flows

4. Dependent on interest rate differentials

The correct answer is: Zero

At the initiation of a swap, the value is defined to be zero. This means that when the swap agreement is first executed, the present value of the future cash flows that are expected to be exchanged between the two parties is equal; therefore, there is no net financial advantage or disadvantage to either party at that point in time. This principle of zero value at initiation is fundamental in swap transactions. It ensures that neither party is disadvantaged at the start of the agreement, reflecting a fair and balanced exchange based on current market conditions. Over time, as interest rates fluctuate and the present value of the cash flows changes, the value of the swap can shift into positive or negative territory for one party or the other. While the other choices relate to important aspects of swaps, they do not correctly define the value at initiation. The market value of bonds involved, present value of future cash flows, or interest rate differentials may come into play in determining values after the swap has been established, but at initiation, these factors balance out to establish a starting value of zero.