Question #4
Reading: Reading 35 Exchange-Traded Funds - Mechanics and Applications
PDF File: Reading 35 Exchange-Traded Funds - Mechanics and Applications.pdf
Page: 2
Status: Correct
Correct Answer: A
Question
A large bank's decision to issue exchange traded notes (ETNs) that track the S&P500 index is most likely to be motivated by the belief that:
Answer Choices:
A. the yield on bank’s unsecured debt would be higher than the swap fixed rate
B. the return on the S&P 500 index would be lower than the bank’s borrowing rate
C. the return on the S&P 500 index would be higher than the bank’s lending rate
Explanation
If a large bank that wants to issue unsecured debt at a fixed interest rate finds that the
rate demanded by the market is significantly higher than the swap fixed rate for same
maturity, the bank may instead issue an ETN that pays the return on an equity index. The
bank then would simultaneously enter into an equity swap as the equity return receiver
and the (swap) fixed rate payer. The index return received is used to service the ETN and
the bank's effective borrowing cost becomes the swap fixed rate.