Chartered Financial Analyst (CFA) Practice Exam Level 2

What do commercial banks primarily use swaps for?

1. To speculate on currency movements

2. To hedge against asset and liability mismatches on their balance sheets

3. To improve transaction efficiency

4. To increase their net interest margin

The correct answer is: To hedge against asset and liability mismatches on their balance sheets

Commercial banks primarily use swaps to hedge against asset and liability mismatches on their balance sheets. This practice allows banks to manage interest rate risk and currency risk effectively. By engaging in interest rate swaps, for instance, banks can exchange fixed-rate payments for floating-rate payments, aligning the characteristics of their liabilities with those of their assets. Through this hedging strategy, banks can protect against the fluctuations in interest rates that might adversely affect their earnings and overall financial stability. Swaps are crucial in risk management as they provide a mechanism to smooth out the volatility that can arise from mismatches between the cash flows of their assets and liabilities. This is particularly important for banks that may have long-term fixed-rate loans funded by short-term floating-rate deposits, creating a potential risk if interest rates were to rise significantly. The other options, while they describe potential uses of swaps, do not capture the primary function of commercial banks in this context. Speculating on currency movements is generally more aligned with traders or financial institutions focused on speculative strategies rather than banks’ primary functions. Similarly, while swaps can improve transaction efficiency and could possibly assist in improving net interest margins, these are secondary benefits rather than the main purpose for their use in risk management.