Since I found that I don’t get it in the solution to 2009 Schweser Practice Exam Book2 Exam 3 Q21.2. I went back to check CFAI’s text (V5, P484, R43) & Scheweser note (LOS C) and I am very much confused by the statements in Scheweser note. IMO, 1.If a floating-rate debt is swaped to a fixed-rate debt => Cash Flow Risk decreases => Market (Equity) Value Risk increase 2. If a fixed-ratedebt is swaped to a floating-rate debt => Cash Flow Risk increases => Market (Equity) Value Risk decrcrease Scheweser note uses “Equty = Asset - liability” to illustrate and it seems the conclisions are contradictory. Anyone can clarify ? TKVM !
Floating rate = lower duration = more CF risk and less MV risk. Fixed rate = higher duration = less CF risk and more MV risk. It’s that simple.
- Think of this like you’re now long a fixed-rate instrument. Duration’s higher for a fixed-rate instrument, vs. a floating. So your market value risk is higher. 2. You’re now long a floating-rate instrument, where you’re uncertain about the size of cash flows from one period to the next (important for a number of reasons)… that’s Cash Flow Risk. I’m not sure why Schweser brings in Equity, but they might be saying that for #2 your equity (= A - L) is going to be less sensitive to interest rate changes, all things equal… you give up some upside though (i.e. if interest rates go down, you don’t benefit as much).
skillionaire & Neveruse_95%_everagain, Your conclusions are same as mine. But it seems Schweser’s conclusions are contradictory.
AMC Wrote: ------------------------------------------------------- > skillionaire & Neveruse_95%_everagain, > > Your conclusions are same as mine. But it seems > Schweser’s conclusions are contradictory. Schweser’s saying exactly what I’m saying. Pretty sure you’re misinterpreting what you typed above.
I would ignore Schweser, quite frankly… I think the guys writing their L3 texts - and particularly their practice exams - have their heads up their a*s. (Disclaimer: I used mostly Schweser last year and failed.)
I will check but I am using 2009 Schweser note. Maybe they have corrected the errors.
skillionaire & Neveruse_95%_everagain, Anyway, now I am sure my conclusions are correct. TKVM !
Sorry to add to the confusion here. I am not understanding what the Equity part and the Asset part means here. Correct me if I am wrong: Assets: What you are managing in order to satisfy the liabilities Equity: Is this the market value of the overall position? (Assets - Liabilities) So, in a previous post, the company had a fixed pay liability (-ve duration) and entered into a swap with a receive-fixed/pay-floating structure. Thus the value of the swap is +ve. But they say, the swap reduces the duration of the liability (How?). And because of this, the duration of the equity (MV?) increases. (How?). So, assets remain the same during this whole process? And just to add, why would you want to increase the duration of equity instead of matching it with the liabilities? Sorry again about this, but in these last few weeks, my retention power has been reduced drastically.
Any1?