Chartered Financial Analyst (CFA) Practice Exam Level 2

What does an issuer aim for when entering into a swap transaction associated with a fixed-rate bond?

1. To pay fixed and receive fixed payments

2. To pay floating and receive fixed payments

3. To eliminate interest rate risk entirely

4. To reduce the risk of default

The correct answer is: To pay floating and receive fixed payments

When an issuer enters into a swap transaction associated with a fixed-rate bond, the primary aim is often to convert their fixed-rate payments into floating-rate payments. This might be driven by a view that interest rates will decline, allowing the issuer to benefit from potentially lower payments in the future. By paying floating and receiving fixed payments in the swap, the issuer can align their cash flow obligations more closely with market movements, creating a more flexible financing structure. Additionally, if the issuer believes that they can manage interest rate risk more effectively or that their revenue streams will fluctuate with interest rates, opting for a floating payment structure can provide potential cost savings. This strategy can be particularly useful in situations where the issuer anticipates a downward shift in interest rates or variability in income. Thus, choosing to pay floating while receiving fixed helps the issuer to manage their interest rate exposure while still maintaining a degree of stability in cash flows by locking in fixed receipts from the swap. Through this approach, issuers can optimize their funding strategy according to market conditions and their own financial outlook.