What’s wrong in the statement: “Put structures will provide investors with some protection in the event that interest rates rise sharply but not if the issuer has an unexpected credit event”?
Item Set 10 - Watanbe - Q4
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Solution says duration of fixed rate bond is 75% of the maturity.—I didn’t find this in Schweser Notes.
Also, I didn’t quite understand why the solutions hasn’t considered the values of duration in the item set. In order to reduce the duration of portfolio from 6.4 to 3.5, it should enter into receive-fixed swap. Hence, simple logic says that duration of the swap will be positive. But the answer provides with only negative durations as the options
swap fixed duration = 75% of term => look for professor’s notes in Schweser (if present).
otherwise check the text - they use this all the time.
should it be receive fixed or receive floating - all depends on the existing position.
if you had a floating rate position - and you want to convert to fixed -> pay fixed, receive floating on the swap, which offsets the pay floating you had before.
Pay Floating Pay Fixed
actually receive fixed will increase your duration - since the fixed position always has a bigger duration than the floating. It should be pay fixed - which will have a negative duration overall.
if interest rates rise sharply - bonds prices would fall, and investor can put the bond back to the Issuer and receive back the par amount. I think - in the event of a negative credit event too - bond prices would rise, and the put would work. So I am guessing that this is what is wrong. (that the put structure does not provide protection in the case of an unexpected credit event).
put structure does not provide protection( or precisly may not be able to provide protection) because issuer might not be able to honor put agreement because of defaults/credit event
