I’m having trouble following Schwesers reasoning in LOS 40c. which deals with the impact of CF and MV risk when converting fixed-for-floating loans. on page 193 they write, “Assume management has entered a fixed-for-floating swap to offset the cash flow risk of a floating rate liability; A TRANSACTION THAT INCREASES THE NET DURATION OF THEIR LIABILITIES WITHOUT AFFECTING THE NET DURATION OF THEIR ASSETS” I understand how the cash flow risk is offset, but I thought the fixed side determines the direction of the duration, and converting to pay fixed has a negative duration and reduces the overall duration [D(pay fixed)=D(floating)-D(fixed) < 0] They go on to try to explain how going the other way (floating for fixed to hedge a fixed liab) will decrease MV risk and increase CF risk and on page 194 write, “Since the duration of the floating-rate liability has been substantially increased by entering the fixed for floating swap, THE NET DURATION OF THE FIRMS LIABILITIES HAS INCREASED. THIS REDUCES THE RESULTING DURATION OF THE FIRM’S ASSETS, meaning MV risk has been REDUCED.” A few things I can’t figure out. 1) it seems they want to explain converting a floating for fixed to hedge a fixed loan but again start explaining about entering a fixed for floating to hedge a floating liability. even so, 2) it starts with the same intro statement as page 193, but now they say the Net Duration has increased, the duration of the assets has changed, and MV risk has been reduced! Is there something I’m missing here? To hedge a floating liability which has cash flow risk but low MV risk due to its uncertain CFs and low duration, converting to a fixed-for-floating will turn the liabiity into a fixed obligation, increasing the duration, decreasing the CF risk and increasing the MV risk. Not sure how asset duration is effected either.
i agree that schweser didn’t explain things well in this part. let me give you my understanding on the subject. point 1. entering into a fixed-for-floating swap converts a floating loan to a fixed one. it stabilize company’s cash flows (i.e. cash flow risk). from CFO’s perspective, it’s a hedge to company’s optimal capital structure. he/she can claim to the board that management does a good job in minimize the WACC (based on a fixed borrowing rate) to maximum shareholder’s value. but, if the loan is floating, CFO would have hard time to make that justification. point 2. you are right, with a fixed loan in the book which is equivalent to shorting a fixed- rate security, as a result, the company assumed a negative duration, i.e. a positive exposure to interest risk. however, if the company is bear stern which had many long positions on fixed income securities in its balance sheet. such a negative duration would indeed reduced company’s total asset duration. this loan position becomes a natural hedge but from quite different perspective. i guess these are what schweser was trying to convey.
I’m going to say that this is a typo and you should report it to Schweser Errata… They were discussing how a Floating for Fixed would affect the balance sheet items, but they ended up writing about the same swap again (with wrong details to boot…)
thanks for the confirmation!