Swaps reading 34

CFA Level III Derivatives
#1

Shit’s confusing, please read with me, from Exhibit 1 one page 361, and the text around it. I’ve written it all out to help my thinking. bear with me pls.

So writing out the exhibit on p361:

IPB (company) needs cash so borrows from PLB (bank) at a floating rate.

  • Bank issues 25m floating rate bond (libor +0.03) to IPB
    • IPB receives 25m principal from bank
    • IPB pays interest of libor + 0.03, and repays principal at end to Bank.

To change the interest payment from float to fixed, IPB approaches SPI (dealer), to enter a swap of the same term. (to avoid risk of rising floating rates, ie paying more interest over time)

  • IPB issues 25m floating rate bond (libor) to dealer
    • Dealer receives 25m from IPB (cancelled out)
    • Dealer pays interest of libor rate
  • Dealer issues 25m fixed rate bond (6.27%) to IPB
    • IPB receives 25m from dealer (cancelled)
    • IPB pays a fixed rate of 6.27%

IPB receives libor in float & pays libor to bank, so net, it ends up paying a fixed rate of 6.27% + 3.00%

So in this swap, IPB

  • receives float – -- – pays fixed, by
  • issuing float bond – borrowing fixed bond, so is
  • long a float bond – short a fixed bond,

Is this still correct? Is the issuer of a bond is long (or short) this bond?

and while i’m at it;

And if one is long (has issued) a (fixed) rate bond, one wants the rates to NOT go up. so Long a bond means Short interest rates. (hence embedded calls). right? (yeah)

So now the main question: The book says (reading 34, p.362, 4 sentences in)

Now let us discuss the duration of a swap. Remember that entering a pay-fixed , receive-floating swap is similar to issuing a fixed-rate bond and using the proceeds to buy a floating-rate bond.

That seems contradictory to the exhibit above, and that’s why i’ve written it out. Where am i going wrong?

The sentence after that, for completeness:

The duration of a swap is thus equivalent to the duration of a long position in a floating-rate bond and a short position in a fixed-rate bond.

#2

If you purchase a bond, you’re long the bond, and long its duration.

If you issue a bond you’re short the bond and short its duration.

If you’re long the bond you haven’t issued it, you own it.

If you own the bond, you don’t want rates to increase, as the value of your asset decreases.

If you’ve issued the bond you want interest rates to increase, as the value of your liability decreases.

You’re going wrong in thinking that issuing a bond is a long position.

When you issue a fixed-rate bond you pay a fixed rate of interest.

When you buy a floating-rate bond you receive a floating rate of interest.

So a pay-fixed, receive-floating swap is equivalent to issuing (selling, being short) a fixed-rate bond and purchasing (being long) a floating-rate bond.

Annotated for complete completeness.

#3

So a pay-fixed, receive-floating swap is equivalent to issuing (selling, being short) a fixed-rate bond and purchasing (being long) a floating-rate bond.

Thanks !

#4

My pleasure.

#5

edit; i guess i need to work on my terminology

I misinterpret ‘issuing a bond’

#6

Issuing a bond means selling it originally: borrowing money from the bondholder.