When I want to extend the duration of the US Treasury portfolio from three years to four years.
To implement BCA’s duration strategy, the Smiths will most likely:
The answer is 1, but why can’t it be 2, am not I getting a fixed rate in the equity swap as well?
paying a floating rate in an equity swap means you will receive equity, which will not increase your duration, the only correct answer showing here is entering in interest rate swap as the fixed rate receiver
[quote=“Appro”]
paying a floating rate in an equity swap means you will receive equity, which will not increase your duration, the only correct answer showing here is entering in interest rate swap as the fixed rate receiver
[/quote
Based on CAFI equity swaps can be interchanged with fixed series, floating or another equity return. In that sense I will still receive a fixed interest rate.
[quote=“carolinesherif”]
Definitely equity swaps can be interchanged with fixed rate, floating rate or another equity, but look at the choices up here to increase your duration , you would either
(i)pay a floating rate and receive equity [which will not increase your duration]
(ii) paying floating receiving fixed rate [which will increase your duration]
When I want to extend the duration of the US Treasury portfolio from three years to four years.
To implement BCA’s duration strategy, the Smiths will most likely:
The answer is 1, but why can’t it be 2, am not I getting a fixed rate in the equity swap as well?
its because in this case the interest rates were falling, that is the other information given and if interest rates are falling you want to pay floating and receive fixed.
Interest Rates Falling {Pay floating receive fixed: Increase duration} or Buy Futures Contracts
Interest Rates Rising {Pay fixed receive floating: Reduce Duration} or Sell Futures Contracts
Just think of the actual durations.
This logic applies to someone who OWNS a bond portfolio, not someone who’s issued a bond.
A floating rate note will have a duration of what? Between zero and a half (potentially one if it’s annual pay bond). Why is that? Because the bond resets it’s coupon payments. Most floating rate notes will have a duration between 0 and 0.5 though. let’s say for this rude example, that the duration of the floater is 0.25.
Now consider the duration of the same maturity, fixed rate note… It will be much larger. Let’s just say the duration in this example for the fixed rate bond is 4.75.
Now, consider what options the investor has to alter the duration of her portfolio.
A payer swap can be essentially viewed buying a floater and issuing a fixed rate bond. and we know from above, that a fixed rate bond has a larger duration than the floater, and since we’re short that duration (since we’ve issued the bond) that we have the duration effect of 0.25 - 4.75 = -4.5 which is as you can see, less than zero. The takeaway? That a payer swap will LOWER THE DURATION of the bond portfolio (to someone who is long bonds).
On the Contrary, a reciever swap can be thought of as buying a fixed rate bond, and issuing a floater. Plug those same numbers in and we have 4.75 - 0.25 = +4.5 which is larger than zero.
Increasing duration can be done buy paying a floating rate and receiving fixed. So, whatever the options are on the exam, look for that combo.