# Interest rate swap question on duration impact

LOS C of the Swaps chapter says:

Explain the effect of an interest rate swap on an entity’s cash flow risk ;

Can someone please explain the following?

If a company has floating rate coupon payments to make on an issued bond, and the company enters into a swap to Pay fixed and Receive floating…

Why is it that duration (hence market value risk) raises?

Doesn’t duration increase based on what’s being received? In this case floating is being received?

I understand that cash flow risk would be reduced since the unknown floating payment is converted to a known fixed payment.

Thanks, totally appreciate your help and time!

If you pay fixed, then:

• Your (negative) duration is high, so you have high price risk.
• Your payments are constant, so you have zero cash flow risk.

If you pay floating, then:

• Your (negative) duration is low, so you have low price risk.
• Your payments are variable, so you have high cash flow risk.

If you have issued a fixed-rate bond and you enter into a pay floating, receive fixed swap, you go from the first case above to the second: you decrease your price risk and increase your cash flow risk.

If you have issued a floating-rate bond and you enter into a pay fixed, receive floating swap, you go from the second case above to the first: you increase your price risk and decrease your cash flow risk.

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I previously read that duration is impacted based on what you receieve…

What i’m not understanding is… if you pay fixed and receive floating… then shouldn’t duration fall because you’re receiving the low duration floating?

:S thanks.

If you hold a bond, you’re long duration.

If you issue a bond, you’re short duration.

Was going to answer the same as the magician… he arrived before though

That’s why he’s the Magician! I still don’t understand though

Suppose that you own a fixed-rate bond whose duration is 5 years. If interest rates increase 1%, your asset is worth 5% less: you’re worse off. That’s positive duration.

Suppose that you issue a fixed-rate bond whose duration is 5 years. If interest rates increase 1%, your liability is worth 5% less: you’re better off. That’s negative duration.

The change of loan value on a floating from interest rate change is low compared to a fixed. Whether you’re a payer or receiver of a bond, given a change in interest rates, the bond value still changes the same for both parties. So you are adding duration.

I work for a bank. Should I think of it like this?:

We issue CDs to depositors, therefore we are short duration;

We use our liquidity portfolio to invest in government bonds (Treasuries), therefore we are long duration;

If we’re trying to manage to duration-neutral, then if I have a positive duration gap (e.g. I’m more long than short), then we would enter into a pay-fixed, receive floating interest rate swap to decrease duration;

If we’re trying to manage to duration-neutral, then if I have a negative duration gap (e.g. I’m more short than long), then we would enter into a pay-floating, receive fixed interest rate swap to increase duration.