Bazlamit suggests using an interest rate swap instead of interest rate call options. She states, “By entering into an interest rate swap in which we receive a floating rate in return for paying a fixed rate of interest, we can hedge against rising interest rates and thus stabilize Viewmont’s cash outflows. The swap will also reduce the sensitivity of Viewmont’s overall position to changes in interest rates.”
The statement is apparently incorrect, b/c the position will increase the position’s sensitivity to interest rates.
If we’re receiving float and paying fixed --> then our duration is lower and we are hedged against rising interest rates. I’m almost thinking that if our duration is lower, we our LESS SENSITIVE to interest rates.
Why is this not the answer and why is it more sensitive to interest rates?
Thanks,
Much apprecaited.
By receiving floating interest rate - the interest rate sensitivity increases.
Think of this - if the floating rates fall immensely - Viewmont would still be paying the fixed rate and all the while receive lower interest in return.
if the floating rates rise immensely - Viewmont wil receive higher interest than usual. So his sensitivity has increased.
Had he been receiving fixed - he would always get the same interest - regardless of any changes in floating interest rates - so his sensitivity is lower
I guess my confusion lies with how its related to duration.
If we want to reduce the duration of a portfolio and are using interest rate swaps we would consider a Receive Float and Pay fixed swap.
Relating interest rate sensitivity to duration is not correct here? I understand your logic but what about duration? If duration is decreasing, shouldn’t it be less interest rate sensitive?
Thanks,
I understand now.
I was thinking of this in terms of just a portfolio. If you have a portfolio with say duration 6.5 and want to reduce that, we use a receive float pay fixed interest rate swap.
This different where we have to consider a loan. If the swap takes us from a fixed to floating loan --> less sensitive. If from floating to fixed --> more sensitive.