Swaps: Market Value Risk

CFA Level III Derivatives
#1

Hey guys,

I am a bit confused with the Market Value Risk topic on Swaps.

It says in the learning material that if a floating rate liability is converted to a fixed rate it in increases the Market Value Risk because of the higher duration of a fixed rate loan.

What confuses me is how can I understand that using the formula:

V(MD Target) = V (MD Portfolio) + NP (MD swap)

My understanding is that the swap reduces duration! Pay float receive fix -> Pay float duration < Receive fix duration. So how does the overall duration of the portfolio increase and therefore the Market Value Risk? Or do I miss something?

Many thanks for any help.

Cheers

Spek

#2

The duration of a swap is (Duration you Receive) - (Duration you Pay), and the duration will always be higher for the fixed leg vs. the floating leg. So if you’re the Fixed Rate Receiver/Floating Rate Payer, your duration increases (receiving a higher duration than you’re paying).

#3

Hi JayWill

Many thanks for your answer.

Excactly, that is also my understandung but here I become a Fixed Rate Payer but it says my Market Value Risk goes up due to the higher duration of the Fixed Rate Liability. I am confused how I can see that in the formula above?

#4

Look this example:

A company which stocks quoted on market has large LIBOR + margin Loan. The management wanted to hedge exposure to floating Interest rates and thus entered into SWAP to lock liability exposure into fixed rate. Few months later, Interest rates rapidly decreased but company still has high fixed rate liability given its SWAP. Thus, its EPS has been decreased and its Market value deteriorated. This is a Market Value risk by locking ino fixed SWAP rate.

#5

When floating rate liabilities are converted to fixed rate, the net exposed duration is that of a fixed rate. This is because the duration of fixed rate bonds are higher than floating rate bonds. Hence, the market value risk always increases in case we convert floating rate payments to fixed rate payments. On the contrary, the cash flow risk reduces since the payments are fixed in nature now.

#6

Looks like I answered the question without actually answering the question again. I better not do that on the exam lol.

#7

Thanks guys I just wonder how I can see that in the formula.

V(MD Target) = V (MD Portfolio) + NP (MD swap)

As with the swap adding a negative duration the duration for the portfolio should go down no? Am I mixing things up?

#8

@Flashback and Viraj,

thanks for your comments. They make completely sense. I just do not get it how to put things now together. In the formulas we say Duration goes up for assets we own (cash inflows) and down for liabilites (cash outflows). Here we have a cash outflow only that is changed from floating to fixed -> a higher negative duration