schweser book 4, page 193 “by hedging against the cash flow risk …” (use a fixed-for-floating swap) “management has exposed the firm to market value risk” i dont quite understand this? say, a mortgage bank has assets with effective duration of 15 years. the management enters into a fixed-for-floating swap to bump up its liability duration from 10 years to 15 years. overall duration = 0. i would conclude the bank has little market risk (at least for the case of parallel shift in rates). help!
Here’s my take. The cash flows (reinvestment risk) has been hedged but price risk remains. That is, the duration isn’t zero as you think. Therefore changes in interest rates (market risk) remain. off the top of my head. Which has proven me wrong once already today.
Fixed-for-float means you receive float payment and pay fix payment. If your firm has liability that has a fix payment (issuing a bond), your liability is exposed to market risk (interest rate) since your liability value can change depend on external interest rate. I think this is right, somebody correct me if I am wrong…it is Friday.
ws Wrote: ------------------------------------------------------- > Fixed-for-float means you receive float payment > and pay fix payment. If your firm has liability > that has a fix payment (issuing a bond), your > liability is exposed to market risk (interest > rate) since your liability value can change depend > on external interest rate. > > I think this is right, somebody correct me if I am > wrong…it is Friday. they are taking company’s asset and liability into one basket and evaluated interest rate exposure for this combined entity, i.e. equity. if it’s just liability, then you are right.
Well, I don’t know what context this is in but hedging exposes you to all kinds of market risk through mark-to-market accounting. For example, suppose that I have a rerstaurant in France with dependable cash flows for the next 10 years so I swap out my Euro exposure. I now have zero FX risk, except my books show a 10-yr swap that is marked-to-market in that FAS-133 sorta way. If the Euro appreciates there is no way that I can show on my books that my future cash flows from my restaurant are worth more dollars. Edit: “future” not “futures”…
If you hold / issue a floating bond, you have CF risk (you receive / pay more or less, depending on Libor or whatever going up / down). That changes your CFs, but usually market value will not change. I remember from cfa level one that floating rate notes only have duration risk between reset dates (or if they have cap, floors, etc) Ok, if you hedge that, converting that floating coupon into a fixed one, your CFs will always be the same (fixed), but the market value of the bond will change (rates go up, bond goes down, and viceversa) as in any regular bond the example in schwesser is more complicated, because instead of “talking about bonds”, they talk about the market value of the company with a floating liability that “fixes” it by entering into a swap… does not matter, the concept is the same
JoeyDVivre Wrote: ------------------------------------------------------- > Well, I don’t know what context this is in but > hedging exposes you to all kinds of market risk > through mark-to-market accounting. For example, > suppose that I have a rerstaurant in France with > dependable cash flows for the next 10 years so I > swap out my Euro exposure. I now have zero FX > risk, except my books show a 10-yr swap that is > marked-to-market in that FAS-133 sorta way. If > the Euro appreciates there is no way that I can > show on my books that my future cash flows from my > restaurant are worth more dollars. > > Edit: “future” not “futures”… this is a very unique perspective. i never thought that way. i agree with you that any particular swap will expose the company in one way or another. but, if one could combine all transactions together to the firm level, the overall risk exposure might be quite different, i.e. the firm-wide risk. this section in schweser’s book seems to be doing just that. here’s quote from the book "the resulting position, however, makes their market value (i.e., market value of equity) more vulnerable. To see this, consider the general balance sheet relationship: equity = assets - liabilities assume management has entered a fixed-for-floating swap to offset the cash flow risk of a floating rate liability; a transaction that increases the net duration of their liability without affecting the net duration of their asset… thus, by hedging against the cash flow risk associated with increasing rate, management has exposed the firm to market value risk. "
Here’s how I see it: Situation: A company has floating rate obligation and converts this into a fixed rate obligation using a fixed for floating rate swap. In effect, the firm has locked in the cash flows. Great. But, if you dig deeper you can see that the firm has gone from a floating rate obligation to a fixed rate obligation. Its known that the duration of a floating rate is smaller than the fixed rate obligation, 'cos interest rates are reset periodically for a floater. What does this mean? It means the floating rate obligation’s market value is set to par every, say quarter, there by removing any effects of market rate changes but with the fixed rate obligation in addition to paying the fixed rate the bond may trade significantly farther away from par if rates change. Hence, the company has eliminated CF risk but has exposed itslef to market risk. Hope it makes sense
i guess i read too much into the immunization and how insurance companies running their businesses. i thought for a CFO of a company, if he’s able to match up durations between company’s assets and liabilities, doesn’t he do a good job in reducing company’s market risk to interest rate?
level2longshot Wrote: ------------------------------------------------------- > Here’s how I see it: > Situation: A company has floating rate obligation > and converts this into a fixed rate obligation > using a fixed for floating rate swap. > > In effect, the firm has locked in the cash flows. > Great. > > But, if you dig deeper you can see that the firm > has gone from a floating rate obligation to a > fixed rate obligation. Its known that the duration > of a floating rate is smaller than the fixed rate > obligation, 'cos interest rates are reset > periodically for a floater. > > What does this mean? It means the floating rate > obligation’s market value is set to par every, say > quarter, there by removing any effects of market > rate changes but with the fixed rate obligation in > addition to paying the fixed rate the bond may > trade significantly farther away from par if rates > change. > > Hence, the company has eliminated CF risk but has > exposed itslef to market risk. > > Hope it makes sense what you said makes perfect sense. but, didn’t answer my question. let me give you my side of story. based on what you said, the swap increases duration of company’s liability (say from 0.25 year to 2 years). this fixed liability becomes more sensitive to rate changes. we all agree. let’s look at company’s asset, it turns out the duration of company’s asset is also 2 years. In this case, MD(equity) = MD(asset) - MD(liab) = 0. conclusion: market value of the company becomes “insensitive” to the rate change even though its liability is.
sorry, still don’t grasp that final point. let’s say that taking pay fixed side of swap will: -->increase liab duration (as you now make fixed payments) -->decrease asset duration as you swap out your fixed receipt leg and replace with floating exposure… so would’t equity duration now be less and not remaining uncahnged? what am i missing?
3rd & Long Wrote: ------------------------------------------------------- > sorry, still don’t grasp that final point. let’s > say that taking pay fixed side of swap will: > > -->increase liab duration (as you now make fixed > payments) > -->decrease asset duration as you swap out your > fixed receipt leg and replace with floating > exposure… no, the company only had its duration for liab changed. it didn’t do anything to its assets.
Rand0m, were you able to resolve your question? If so, please share. Schweser discussion of this topic is confusing. Quoting from the same page you quoted earlier: “Since the fixed-for-floating swap has increased liability duration without changing duration of the assets, the duration of the firm’s equity has fallen” - so far, i agree “This means, the market value of the firm’s equity is less sensitive to changes in interest rates, …” - does not that imply that Market Value Risk of firm’s equity decreased?
i guess the takeaway from this topic is that a company should treat asset and liability as a whole package when it comes to making decisions on interest rate hedging. but, i dont think schweser made good argument to support this correct view. using examples might be easier to express myself. scenario 1. a company’s assets (thinking of microsoft) are mainly cash-like in form of cash, receivables, etc. assume its asset duration is something like 0.5. when this company hedges its long-term debt by increasing duration from say 0.5 years to 3 years. the overall equity duration changes from 0 to -2.5 (assume asset value equals to liability value for simplicity). mathematically, the number gets smaller, but what counts is its absoute value. For this company, hedging decision makes the company more sensitive to rate changes. scenario 2. a company’s assets (thinking of countrywide) are mainly bond-like in form of mortgages, comercial loans, etc. assume its asset duration is something like 3. when this company hedges its long-term debt by increasing duration from say 0.5 years to 3 years. the overall equity duration changes from 2.5 to 0 (assume asset value equals to liability value for simplicity). For this company, hedging decision makes the company less sensitive to rate changes. even though, the claim that “Since the fixed-for-floating swap has increased liability duration without changing duration of the assets, the duration of the firm’s equity has fallen” is always ture mathematically, but not so if one has to equate it to the sensitivity of rate movement (or market risk). i think i am through with this subject by acknowledging that schweser asked a math student instead of finance student to take its notes.
Thanks, rand0m!