Skinner has been consulting with Dwayner Brter, a client of Director securities and CFO of a large corporation. Barter is interested in using interest rate swaps to convert his firm’s floating rate debt to fixed rate debt. Barter is planning to enter into a swap to pay a fixed rate and receive a floating rate in exchange. How would the swap impact the firm’s debt?
Answer : A: increase the market value risk
If I take the following equation for a pay fixed
Dpay-fixed = Dfloating – Dfixed < 0
Dfloating = Receive floating
Dfixed = Pay fixed
Per the above the duration has reduced { - L (original bod) + L ( Receive floating) – SFR (Pay fixed) }
Is my understanding correct either an asset or a libiality with a fixed rate has longer duration hence higher market risk and lower cash flow risk.
I am struggling to put the concept into the equation.
Fixed sides of swaps have higher duration (0.75 of maturity) than float sides (0.5 of payment interval) thus when you eliminate float payments and are left with fixed, market value risk increases, cash flow risk decreases to 0. This answer does not specify whether you are long or shot net duration (positive or negative market value risk) but it just says that it increases (in absolute value).
Anything fix will have a higher market risk than floating. Anything floating will have a higher reinvestment risk than fix.
The logic is even if interest rates fall you still have to pay the high fix coupon. The liability will increase, since coupon fix, yield dropped and everything else is the same. Changes in the liability value due to interest rateis market risk.
If the coupon is floating, the interest rate might change (fallen), but since it’s floating, the market value should remain constant (coupon changes to reflect yield). However if interest rate raise too much your paying more and interest payments for the loan. The market value is the same, but your paying more coupon (reinvestment risk).