Lopez also recommends that WMTC reduce the duration of the bond portfolio by 50%. She states that, in order to achieve this duration target, WMTC should use a 6-year interest rate swap with semiannual payments. Lopez estimates the duration of the swap’s fixed payments to be 75% of the swap maturity.
The following are proposed answers:
To achieve the target duration for the pension plan’s bond portfolio, WMTC should enter into an interest rate swap with a modified duration that is:
negative, requiring WTMC to make fixed rate payments and receive floating rate payments.
negative, requiring WTMC to make floating rate payments and receive fixed rate payments.
positive, requiring WTMC to make fixed rate payments and receive floating rate payments.
I always thought that reducing making floating rate payment reduces duration - what am I getting wrong?
When you receive fixed payments, there is high price risk and in turn higher duration. When receive floating rates, your CFs keep changing with changin interest rates keeping your duration pretty much constant.
The answer is A. If we want to increase duration of the bond owned (assets), we long fixed bonds. But this is a liability. So if we want to reduce duration of the bond (liability) we go long fixed rate. Or I am totally getting this wrong?
No. If you wanna reduce duration, enter a payer swaption (pay fixed, get received). If you receive Fixed, the value of your swap will change by a higher % (high duration) as compared to when you receive floating.
If you think about it, this statement is silly. The change in value is the same whether you’re paying the fixed rate or receiving the fixed rate; they’re simply in opposite directions.
Your question above says they want to reduce the duration of the pension plan’s bond portfolio. It is definitely an asset, the liabilities of the pension plan are not bonds but the PBO. Bonds are their asset with which they immunize their liabs.
Thanks everyone. The answer is actually much simpler than I originally thought. One needs to watch at things from perspective that going long fixed rate increases duration. So if you go long on fixed rate and short on floating rate you are effectively increasing duration because D(fixed)>D(floating). A comparison can be seen in bonds. Finally if you want to reduce duration you go short fixed and long floating.