EOC reading 31, question 2b

[libero28]

Asked which of the two swaps is better for hedging, both pay floating and receive fixed. The correct answer is the 4-year pay floating quarterly vs the 3-year pay floating semi-annually. Is this because the notional is lower under this scenario? Answer does not say this, it only says that because the objective is to increase duration, the 4-year option is the better choice. Both increase duration so not understanding.

Any explanation appreciated. Thanks

[perdition]

The idea is to try to keep the notional closest to that of the original swap.

Only 1 of these achieves that…appreciate the notional is not exactly as before!

[libero28]

Thanks but I’m not following.

What is the original swap? The two swap choices are for a portfolio of 100m. The three year swap has a notional of 100m, which is exactly the same, cf the four year swap of 69m.

[janakisri]

4 yr duration is 3.875. 3 yr duration is 2.75. So dollar duration is higher for 4 yr meeting the objective better

[libero28]

Sorry, are we looking at the same question here? The answer actually gives the duration of each (2.875 and 2.0) so not sure where you get your numbers from. What does dollar duration have to do with it? “The answer says the objective is to increase the duration of the bond portfolio - the four-year pay-floating, receive fixed swap is the better choice”. So, both choices satisfy the objective… Why the preference?

If someone could please provide an answer that is consistent with the material given in the question, answer and info in the reading I would be very grateful!

[cpk123]

4 (0.75) - 0.125 = 2.875

3 (0.75) - 0.25 = 2

u want to change the duration from 1.5 to 3.5 -> so 1) closer to 3.5 is a better choice

and 2) this gives you a lower notional Principal investment.

book says this pg 452

The terms of the swap will affect the need to renew it as well as its duration and the notional principal required. It would probably be best for the swap to have a maturity at least as long as the period during which the duration adjustment applies. Otherwise, the swap would expire before the bond matures, and QAM would have to initiate another swap. The maturity and payment frequency of the swap affect the duration

and again on pg 453

With this longer duration, the notional principal would be about $464 million, a much more reasonable amount, although still a fairly large swap.

[libero28]

Thanks for that.

I think I may have read too much into it. However, the choice of 69m vs 100m seems trivial compared to the 3.25b vs 464m example in the text but point taken.