Swaps reading 34
****’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.
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