On question Nr 43, it is asked how to reduce duration with an IRS.
pay fixed or pay floating.
I choosed pay fixed, but the answer is pay floating and it doesn’t makes sense to me.
Schweser: "The CFO is looking to reduce the duration of the fixed-rate bond. A pay floating and receive fixed is most likely to achieve this objective. "
If you have a fixed-rate bond, you are paying interest expense, or paying fixed rates.
To reduce or hedge against the risk of a declining interest rate (since you’ll be paying higher than market rates if that happens), you enter into a swap to pay float and receive fix
By doing that, you offset your pay fix position by receiving fix on the swap, and ultimately pay float. This allows you to pay a lower rate if interest rates decline
Hope that helps
Sorry but if I have a fixed rate bond, I am receiving fixed rates (I receive the coupon).
In fact the answer from the Schweser is contraddictory with another similar exercise on another mock. Moreover, this is from the CFA book:
“Consider a portfolio manager with an investment portfolio containing $500 million of fixed-rate US Treasury bonds with an average duration of five years. Suppose the manager wants to reduce this duration to three over the next year but does not want to sell any of the securities. One way to do this would be with a pay-fixed interest rate swap. Because the portfolio is currently receiving a fixed rate , the manager will want to exchange part of this fixed-rate income stream for a floating-rate stream in order to lower the overall duration. This approach means the appropriate swap would pay the fixed rate and receive the floating rate.”
Sorry yx5353, I might be wrong, because in this exercise I have bond OUTSTANDING I have not bought the bonds as I wrongly thought.
You are right, didn’t read very well the situation in the exercise…
As rightly pointed out by you, these are bond outstanding
And as Schweser has succinctly put it, “Because the portfolio is currently receiving a fixed rate , the manager will want to exchange part of this fixed-rate income stream for a floating-rate stream in order to lower the overall duration.”
Hope this helps