DFOL: Swaps

Topic snapshot

Swaps checklist before the questions

Swap questions test exchanged cash flows and the risk being transformed. Identify what each party pays, what each party receives, and which exposure the swap is meant to change.

• Interest-rate swaps usually exchange fixed and floating rate exposure.
• Currency swaps add foreign-exchange and cash-flow matching issues.
• The main risk may be counterparty, valuation, liquidity, or basis risk rather than directional market risk alone.

What to drill next after swap misses

If you miss these questions, write each leg of the swap separately. Then drill fund and structured-product questions where swaps may appear inside a product wrapper.

Sample questions

These questions are original Securities Prep practice items aligned to this topic area. They are designed for self-assessment and are not official exam questions.

Question 1

Topic: Swaps

A Canadian greenhouse operator expects to buy 10,000 GJ of natural gas each month for the next six months. It wants to lock in its effective gas cost, keep purchasing the physical gas from its regular supplier, and avoid daily exchange margin calls. A dealer proposes an OTC agreement that will be cash-settled monthly against the AECO natural gas index. Which structure best meets the operator’s objective?

• A. Pay fixed and receive floating on a monthly notional volume
• B. Buy AECO call options for the six-month gas needs
• C. Buy AECO futures and manage daily margin calls
• D. Receive fixed and pay floating on a monthly notional volume

Best answer: A

What this tests: Swaps

Explanation: A basic commodity swap is usually a fixed-for-floating cash-settled agreement on a notional quantity of the commodity. Because the greenhouse will be buying gas, paying fixed and receiving floating offsets rising AECO prices while letting it keep its normal physical supplier.

A commodity swap is an OTC contract in which payments are based on a notional quantity of a commodity and a reference price, such as AECO for natural gas. The usual structure is fixed versus floating: one party pays a fixed price, the other pays a floating price tied to the benchmark, and the net difference is cash-settled on each payment date. A firm that expects to buy the commodity is exposed to rising prices, so it typically wants to pay fixed and receive floating. If the benchmark rises, the floating receipts from the swap help offset the higher physical purchase cost; if the benchmark falls, the swap payment is offset by cheaper physical gas. This creates an approximately fixed effective input cost. The opposite payment direction is more suitable for a producer seeking to lock in a selling price.

• Receive fixed suits a producer or inventory holder hedging against falling commodity prices, not a future buyer worried about rising input costs.
• Call options can cap upside risk, but they do not create the basic fixed-for-floating swap structure and still involve a premium.
• Futures can hedge price risk, but the stem specifically rules out daily margin calls and asks for an OTC cash-settled arrangement.

A commodity buyer locks in an effective purchase price by paying fixed and receiving the floating commodity index on a cash-settled notional amount.

Question 2

Topic: Swaps

A Canadian pension fund holds $10,000,000 face value of Glacier Rail Ltd. bonds. All amounts are in CAD.

Exhibit: CDS term-sheet note

Reference entity: Glacier Rail Ltd.
Notional: \$10,000,000
Protection buyer: Northern Pension Fund
Protection seller: Prairie Bank
Premium: 175bp annually, paid quarterly by buyer
Credit events: bankruptcy, failure to pay
Settlement: cash

Based on the exhibit, what is the only supported interpretation of this trade?

• A. It transfers Glacier Rail credit risk from the fund to Prairie Bank.
• B. It requires the fund to sell its Glacier Rail bonds to Prairie Bank now.
• C. It guarantees the fund a gain if Glacier Rail bond yields fall.
• D. It transfers Glacier Rail interest-rate risk from Prairie Bank to the fund.

Best answer: A

What this tests: Swaps

Explanation: This is a credit default swap, a type of credit derivative. The pension fund is the protection buyer, so by paying the quarterly premium it shifts Glacier Rail’s default risk to Prairie Bank, the protection seller.

A credit derivative is a contract whose value depends mainly on the credit quality of a reference entity. In a credit default swap, the protection buyer pays a periodic premium, and the protection seller agrees to compensate the buyer if a stated credit event occurs, such as bankruptcy or failure to pay.

Here, the fund owns Glacier Rail bonds and is listed as the protection buyer, so the CDS is being used to transfer credit risk on Glacier Rail to Prairie Bank. The exhibit does not indicate any transfer of bond ownership, and the listed triggers are credit events rather than interest-rate changes. Because settlement is cash, a credit event would lead to a cash payout under the CDS rather than an automatic sale of the bonds.

The key takeaway is that a CDS separates and transfers credit risk without necessarily transferring the underlying asset.

• Interest-rate mix-up fails because the contract is triggered by bankruptcy or failure to pay, not by rate movements.
• Immediate bond sale is unsupported because a CDS can hedge credit exposure while the investor continues to hold the bonds.
• Yield-decline profit is wrong because the protection is tied to adverse credit events, not to bond price gains from falling yields.

The protection buyer pays a premium so the protection seller assumes the defined credit-event risk on the reference entity.

Question 3

Topic: Swaps

Maple Components Ltd., a Canadian company, wants USD funding for a 3-year U.S. project. It enters an OTC currency swap with these terms:

Inception: Maple pays CAD 27,000,000 and receives USD 20,000,000
Every 6 months: Maple pays 4.8% on USD 20,000,000 and receives 5.4% on CAD 27,000,000
Maturity: the same principal amounts are re-exchanged

What is the best interpretation of Maple’s cash-flow profile?

• A. It synthetically converts CAD funding into USD funding and locks the principal re-exchange.
• B. It exchanges only the net interest difference, with no principal exchange.
• C. It gives Maple the right, but not the obligation, to re-exchange principal.
• D. It leaves the maturity principal exchange to be set at the future spot rate.

Best answer: A

What this tests: Swaps

Explanation: A currency swap typically exchanges principal in two currencies at inception, exchanges interest payments during the term, and re-exchanges the original principal amounts at maturity. Here Maple receives USD upfront and pays USD interest, so it has effectively obtained USD financing while locking the principal exchange amounts.

The core concept is that a currency swap combines an exchange of notional principal with ongoing interest payments in different currencies. In this case, Maple delivers CAD principal and receives USD principal at the start, then pays interest on the USD amount and receives interest on the CAD amount. That cash-flow pattern is economically similar to borrowing USD and lending CAD.

Because the stem says the same principal amounts are re-exchanged at maturity, the principal exchange is set by the original swap terms rather than by whatever the spot exchange rate is in 3 years. That is a defining structural feature of a standard currency swap. It is not an option, because both parties are obligated to perform the exchanges under the contract.

The key takeaway is that the swap transforms Maple’s funding exposure from CAD into USD using fixed principal exchanges and periodic interest flows.

• Net interest only confuses a currency swap with a plain-vanilla interest rate swap; the stem explicitly includes principal exchanges.
• Right but not obligation describes an option, not a swap with binding bilateral cash flows.
• Future spot at maturity is inconsistent with re-exchanging the same stated principal amounts.
• Synthetic funding fits because Maple receives USD principal and services USD interest over the life of the swap.

Receiving USD principal and paying USD interest makes the position synthetic USD funding, while re-exchanging the original notionals locks the principal FX rate.

Question 4

Topic: Swaps

All amounts are in CAD. A Canadian manufacturer has a $25 million 3-year bank loan that resets quarterly at a floating reference rate plus 1.2%. Management expects short-term rates to rise and wants predictable interest expense, but it will keep the loan outstanding and does not want to exchange principal. Which derivative structure is the single best recommendation?

• A. Enter a CAD/USD currency swap with principal exchange.
• B. Enter a pay-floating, receive-fixed plain-vanilla swap.
• C. Buy an interest rate cap on the floating-rate loan.
• D. Enter a pay-fixed, receive-floating plain-vanilla swap.

Best answer: D

What this tests: Swaps

Explanation: A plain-vanilla interest rate swap exchanges fixed and floating interest cash flows on a notional amount, usually without exchanging principal. For a borrower that already pays floating and wants stable payments, the standard structure is to pay fixed and receive floating.

In a plain-vanilla interest rate swap, the notional principal is used only to calculate interest payments; it is not normally exchanged. One party pays a fixed rate and receives a floating rate, while the other does the reverse. Here, the company already has floating-rate debt and wants predictable interest expense. By entering a swap that pays fixed and receives floating for the same notional amount and similar term, the floating receipts from the swap offset the loan’s floating-rate exposure, leaving a more stable net fixed borrowing cost plus the loan spread.

• Match the swap notional to the loan amount.
• Match the term and reset frequency as closely as practical.
• Use pay-fixed/receive-floating to hedge floating-rate debt.

A rate cap can reduce upside rate risk, but it does not create the fixed-for-floating exchange that defines a plain-vanilla swap.

• The pay-floating/receive-fixed structure is the opposite exposure and is more suitable for converting fixed-rate debt into floating-rate debt.
• The currency-swap choice introduces foreign-exchange exposure and typically involves principal exchanges, which the company does not want.
• The interest-rate cap limits how high the rate can rise, but borrowing costs still remain floating below the cap.

This structure offsets the loan’s floating-rate exposure without exchanging principal, effectively converting the borrowing to synthetic fixed-rate debt.

Question 5

Topic: Swaps

A Canadian corporation may complete an acquisition in 90 days and, if it closes, will issue 5-year floating-rate debt. The treasurer expects swap rates could rise before then and wants the ability to convert that future borrowing to fixed, but does not want a binding swap if the acquisition is cancelled. The firm is willing to pay an upfront premium and wants any loss limited to that premium. Which strategy best meets this objective?

• A. Buy a receiver swaption on a 5-year CAD interest rate swap
• B. Buy a payer swaption on a 5-year CAD interest rate swap
• C. Enter a 5-year pay-fixed, receive-floating swap today
• D. Buy a 5-year interest rate cap starting in 90 days

Best answer: B

What this tests: Swaps

Explanation: A swaption is an option on an interest rate swap. Here, the firm wants protection against rising fixed swap rates while keeping the choice to walk away if the acquisition does not close, so a payer swaption is the best fit because the maximum loss is the premium.

The key concept is that a swaption gives the holder a future choice about entering an interest rate swap. A payer swaption gives the right to become the fixed-rate payer and floating-rate receiver in a swap, which matches a firm that expects future floating-rate debt and may want to lock in a fixed rate later. Because the acquisition may not close, entering the swap now would create an unwanted obligation. A receiver swaption is the opposite direction, and a cap hedges floating-rate interest directly rather than providing the right to enter a swap at a preset fixed rate. The best match is the instrument that preserves flexibility and limits loss to the premium.

• Immediate swap fails because it creates a binding hedge now, even if the financing never occurs.
• Wrong swaption side fails because receiving fixed and paying floating does not match converting future floating-rate debt to fixed.
• Interest rate cap fails because it limits floating-rate cost but does not give the right to enter the desired swap.

A payer swaption gives the firm the right, but not the obligation, to enter a pay-fixed, receive-floating swap later.

Question 6

Topic: Swaps

A Canadian pension plan owns CAD 20 million face value of Maple Telecom bonds and wants to hedge the risk of a default with an OTC credit default swap on Maple Telecom. Before the trade is booked, the derivatives analyst must complete the ticket showing the plan’s side and expected cash flows. What is the best next step?

• A. Enter the CDS first, then assign buyer and seller roles during confirmation.
• B. Record the plan as protection buyer: pay premiums and receive settlement after a credit event.
• C. Wait for a credit event, then assign buyer and seller roles on the ticket.
• D. Record the plan as protection seller: receive premiums and owe settlement after a credit event.

Best answer: B

What this tests: Swaps

Explanation: In a CDS, the protection buyer transfers credit risk by paying a periodic premium. Because the plan owns the bonds and wants a hedge, it should be entered as protection buyer; the protection seller would make the contingent payment if a credit event occurs.

A credit default swap transfers the default risk of a reference entity from one party to another. The party that wants protection on a long credit exposure is the protection buyer. It pays the CDS spread periodically until maturity or a defined credit event, while the protection seller receives that spread and must make the settlement payment if a credit event occurs.

Here, the pension plan already owns Maple Telecom bonds and wants to hedge potential default loss. That means the correct workflow step before booking the trade is to label the plan as protection buyer and set the premium payment direction accordingly. Recording the plan as seller would increase credit exposure instead of hedging it, and delaying role assignment until confirmation or default is operationally incorrect.

• Reversed hedge: the option making the plan protection seller would earn premium but leave the plan owing payment after a credit event.
• Too late in process: the option delaying role assignment until confirmation skips a core trade term that must be set at booking.
• Confuses cash flows: the option waiting for a credit event ignores that CDS buyer and seller roles, and premium payments, begin from trade date.

A bondholder seeking default protection is the protection buyer, so it pays the CDS spread and receives the contingent payment if a credit event occurs.

Question 7

Topic: Swaps

A Canadian utility has a CAD 100 million 3-year bank loan at CORRA + 1.10%, resetting quarterly. To reduce interest-rate uncertainty, it enters a plain-vanilla interest rate swap on the same notional and reset dates in which it pays fixed 3.40% and receives CORRA, with net settlement each quarter. What is the best interpretation of the utility’s resulting interest-cost profile?

• A. It is now more exposed to rising CORRA.
• B. It benefits most if CORRA falls sharply.
• C. It has removed the 1.10% loan spread.
• D. It has synthetically locked in about 4.50% fixed borrowing.

Best answer: D

What this tests: Swaps

Explanation: This swap is being used to change the utility from floating-rate borrowing to synthetic fixed-rate borrowing. Because the swap’s received CORRA matches the loan’s CORRA exposure, the floating benchmark largely cancels out and the utility is left paying about 3.40% + 1.10% = 4.50%.

An interest rate swap lets a borrower change its rate exposure without replacing the original loan. Here, the utility still owes its lender CORRA + 1.10%, but under the swap it receives CORRA and pays fixed 3.40%. Because the swap’s floating leg matches the loan benchmark and reset pattern, the CORRA amounts largely offset each other.

• Loan: pay CORRA + 1.10%
• Swap: receive CORRA, pay 3.40%
• Net result: pay about 4.50% fixed

This is why firms use fixed-for-floating swaps: to convert uncertain floating payments into more predictable fixed payments. The closest mistake is assuming the swap also removes the lender’s spread, but that credit spread remains part of the borrowing cost.

• More floating exposure fails because the received CORRA offsets, rather than adds to, the loan’s CORRA payments.
• Benefit from falling rates fails because the combined position is largely fixed after the benchmark offset.
• Spread disappears fails because the swap changes benchmark exposure, not the bank’s 1.10% lending spread.

Receiving CORRA offsets the loan’s floating benchmark, leaving roughly the fixed swap rate plus the loan spread, or 4.50%.

Question 8

Topic: Swaps

A Canadian company with mostly CAD revenues has USD 10 million fixed-rate debt outstanding. It agrees with its bank on a standard 3-year deliverable OTC currency swap to synthetically convert that obligation into CAD, and the parties have already set the notional principals using the current spot rate, the fixed rates in each currency, and the semi-annual payment dates. What is the best next step?

• A. Net only the interest difference in CAD each period.
• B. Wait until maturity to exchange principal and settle all interest then.
• C. Exchange principal now, but settle both interest legs only in CAD.
• D. Exchange principals now, pay interest in each currency, and re-exchange at maturity.

Best answer: D

What this tests: Swaps

Explanation: A standard deliverable currency swap involves more than swapping interest differentials. After the terms are set, the parties exchange notional principal at the start, exchange interest cash flows in the two currencies during the swap, and re-exchange principal at maturity.

The core concept is the structure of a standard deliverable currency swap. Once the parties agree on the notional amounts, rates, and payment dates, the swap is implemented through three cash-flow stages: an initial exchange of principal, periodic interest payments on each currency leg, and a final re-exchange of principal at maturity. That sequence is what converts the company’s USD debt exposure into CAD cash flows for the life of the hedge.

Interest is based on each leg’s notional amount and is paid in that leg’s currency. Because two currencies are involved, a currency swap is not simply a single net interest payment in one currency. The closest misconception is treating it like a plain-vanilla interest rate swap, which does not require exchanging principals in different currencies.

• Net interest only confuses a currency swap with an interest rate swap and omits the principal exchanges.
• One-currency interest settlement is wrong because each swap leg has interest cash flows in its own currency.
• Maturity-only settlement skips the inception principal exchange and ignores the periodic interest-payment process.

A standard deliverable currency swap exchanges notional principal at inception, periodic interest in each currency during the term, and principal again at maturity.

Question 9

Topic: Swaps

A Canadian regional airline buys jet fuel each month and wants to reduce cash-flow uncertainty for the next six months. After confirming the exposure and that an OTC hedge is suitable, the firm’s bank recommends a commodity swap. Before documents are drafted, the treasurer asks how the swap would be structured. What is the best next step?

• A. Arrange monthly physical fuel delivery through the swap.
• B. Set a notional volume, term, benchmark, and fixed-for-floating cash settlements.
• C. Open a futures margin account for daily variation margin.
• D. Pay the full six-month fuel cost upfront.

Best answer: B

What this tests: Swaps

Explanation: A commodity swap is usually an OTC fixed-for-floating agreement on a stated notional quantity over a stated term. For a fuel user, the next step is to define the volume, benchmark price, and settlement structure so periodic net cash flows can offset changes in fuel costs.

In its basic form, a commodity swap is an OTC contract where one party pays a fixed commodity price and the other pays a floating price linked to a reference index for a notional volume over a set term. The physical commodity is usually still bought in the cash market; the swap separately creates periodic net cash settlements that help stabilize the hedger’s effective cost. For a jet-fuel user, the practical setup is to specify the notional volume, benchmark, settlement dates, and fixed swap price. If market prices rise above the fixed price, the floating leg helps offset higher fuel purchase costs; if prices fall, the hedge works in the opposite direction. Treating the swap as a prepaid purchase, a delivery contract, or a futures account confuses it with different instruments.

• The upfront-payment idea describes a prepaid supply arrangement, not a standard swap structure.
• The delivery idea confuses a financial hedge with a physical commodity purchase contract.
• The futures-account idea applies exchange-traded futures mechanics, not an OTC commodity swap.

A commodity swap is typically built around a notional quantity and term, with periodic net cash settlements between a fixed price and a floating commodity benchmark.

Question 10

Topic: Swaps

A Canadian pension fund is reviewing the CDS note below. All amounts are in CAD.

Exhibit: CDS term-sheet note

Protection buyer: Northern Pension Fund
Protection seller: Dealer Alpha
Reference entity: Prairie Power Inc.
Notional: \$10,000,000
CDS premium: 250bp per year, paid quarterly by the protection buyer
Term: 5 years, unless a credit event occurs earlier
Settlement after credit event: Cash; seller pays (100 - final price)% x notional

If a credit event occurs and the final price is 35% of par, which is the only supported interpretation?

• A. Dealer Alpha pays Northern Pension Fund CAD 3,500,000, and future premiums continue.
• B. Dealer Alpha pays Northern Pension Fund CAD 6,500,000, and future regular premiums stop.
• C. Northern Pension Fund keeps paying quarterly premiums and receives no settlement.
• D. Northern Pension Fund pays Dealer Alpha CAD 6,500,000, and future regular premiums stop.

Best answer: B

What this tests: Swaps

Explanation: In a credit default swap, the protection buyer pays the ongoing premium and the protection seller makes the credit-event payment. With a 35% final price, the loss is 65% of CAD 10,000,000, so the seller pays CAD 6,500,000 and future regular premiums end.

The core concept is the direction of cash flows in a CDS. The protection buyer pays the periodic CDS premium, while the protection seller compensates the buyer if a defined credit event occurs. The exhibit states both points directly: the buyer pays 250bp quarterly, and after a credit event the seller pays based on the loss from par to final price.

• Loss percentage = 100% - 35% = 65%
• Cash settlement = 65% x CAD 10,000,000 = CAD 6,500,000
• The CDS ends at the credit event, so future regular premium payments do not continue

The closest distractors either reverse the buyer and seller roles or mistake the 35% final price for the payout percentage.

• Role reversal fails because the protection buyer pays premiums rather than compensating the seller after default.
• Wrong payout base fails because 35% is the final price, so the payment is based on the remaining 65% loss.
• Premiums continue fails because the note says the contract runs until maturity unless a credit event occurs earlier.
• No settlement fails because the exhibit explicitly provides a cash payment after a credit event.

The protection seller owes the 65% loss amount, or CAD 6,500,000, and future regular premium payments end because the CDS terminates on the credit event.

Continue with full practice

Use the DFOL Practice Test page for the full Securities Prep route, mixed-topic practice, timed mock exams, explanations, and web/mobile app access.

Related focused pages

• Free DFOL Full-Length Practice Exam
• DFOL: An Overview of Derivatives
• DFOL: Futures Contracts
• DFOL: Exchange Traded Options
• DFOL: Fund and Structured Product Derivatives
• DFOL: Option Strategy Risk and Reward
• DFOL: Opening and Maintaining Option Accounts
• DFOL: Clearing Corporations and Options Exchanges
• DFOL: Contract Adjustments and Non-Equity Option Risks

Free review resource

Read the DFOL guide on SecuritiesMastery.com, then return to Securities Prep for timed practice.