Final answer:
The correct answer is option d. Statement D, which claims that parities exchange debt obligations during interest rate swaps, is not true. Instead, parties only exchange the interest payments calculated on a notional principal; they do not exchange the underlying debt itself. All other statements about interest rate swaps and their attributes are accurate.
Step-by-step explanation:
When discussing interest rate swaps, it's important to understand their characteristics to identify which statement provided is not true. Interest rate swaps involve two parties exchanging cash flows, where typically one party pays a fixed interest rate and the other pays a floating rate, both calculated on a notional principal amount. Such swaps allow parties to manage their exposure to interest rate fluctuations. Payments can indeed be made on different schedules, including quarterly and semi-annually, and default risk is always a concern in any credit transaction.
Statement A is true as payments in a swap are indeed based on a notional principal amount, which means that the principal amount is not actually exchanged but is used to calculate the cash flows. Statement B is accurate because if interest rates fall, the party paying the floating rate pays less over time and therefore stands to profit. Statement C is factual as the payment frequency can vary between transactions. Therefore, the incorrect statement is D, which says that parties exchange debt obligations. In an interest rate swap, the parties do not exchange the underlying principal or debt obligations; they only exchange interest payments.
Further illustration about the nature of bonds and their risks highlights the point that even with predetermined payments based on a fixed rate of interest, bonds are subject to market risks. As interest rates rise, the present value of the fixed interest payments decreases, which means the market value of the bond falls. This is an important consideration for investors and shows that there is an inherent risk in bond investing due to interest rate fluctuations.