Hi,
I am confused with the duration of swaps (i.e. fixed vs Floating).
I understand that by receiving fix & paying floating (in interest rate swap)- duration increases.
However, in LOS 38 c. (Schweser book 4 page 225) - it says that by paying fix and receiving, increases the liability duration.
Help required!!
I do not have schweser,
but I think this is the case where the manager has a floating rate loan – low duration (if 6 months floating rate payments- avg duration = 3 months = -0.25 year). [It is -ve duration since he is PAYING floating).
He expects interest rates to rise - so enters into a swap to pay fixed, receive floating, essentially converting his position (liability) into a fixed rate payment. If he enters into a 2 year semiannual swap where he pays fixed, receives floating … he is effecting adding on -1.5 (0.75*2) + 0.25 = -1.25 duration to his existing -0.25 - so his total duration = -1.5 (6x times his original position).
Thanks for the reply!
I agree with your point.
However, in Schweser it says that this transaction will increase the duration of liabilities (i.e. Market Risk).
If you receive fixed and pay floating, that will increase the duration of your _ assets _ (or decrease the duration of your _ liabilities _).
If you pay fixed and receive floating, that will decrease the duration of your _ assets _ (or increase the duration of your _ liabilities _).
The latter agrees with what’s in Schweser.
Mind which side of the balance sheet you’re on.
On a side note, Receiving Float also increases Cash Flow Risk.
I think receiving float (paying fixed) decrease cast flow risk, isn’t it?
if you entered into a Swap to Pay Fixed, Receiving Floating - Cash flow risk is reduced because you know exactly how much you would pay - which is the “Fixed Rate on Swap” + Spread ( what you paid on your liabilities - the Floating Rate Received on Swap).
Since it is a fixed amount of payment (largely) it reduces Cash flow risk.
However Market Value risk increases - since this is entered into when rates rise - and this means that your bond portfolio is falling in value.
No more (nor less) than paying floating increases cash flow risk. It’s the same (amount of) risk either way.
Is it common knowledge that the duration of the received-fixed side of a swap is 75% of the maturity of the swap. I did the 2012 CFAI Mock and one of the questions required me knowing that - not something I’ve read in Schweser for sure.
For ex : the fixed side of a 3 year swap has a duration of 2.25 (3 x 0.75). I guess I learned something today that I did not know was required knowledge!
There’s the same amount of cash flow risk on each side; neither one (by itself) decreases cash flow risk.