I’ve seen this question on a few schweser exam questions. When you have a swap say that is pay floating and receive fixed. The question asks, “if interest rates go up, company A’s…” a)Mkt value risk and cash flow risk will increase b)Mkt value risk will increase and cash flow risk will decrease c)Mkt value risk will decrease and cash flow risk will increase Can someone explain to me what the meant by market value risk and cash flow risk as it relates to swaps?
B. You are now receiving fixed payments every period and paying something uncertain. You know for certain what cash flows you should be getting since its fixed, however, there is the risk that you might not get that exact cash flow. Therefore you are exposed to cash flow risk. On the other hand, you are paying floating, so the counterparty has to worry about what the prevailing market rates will be because his payment depends on LIBOR or whatever other benchmark…nonetheless, that rate is determined by the market.
oops…wrong choice. I meant C. I’m done for the night.
I thought that when you pay floating and receive fixed, your overall duration increases… hence, market value risk should go up, no? (market value of the bond will go down as interest rates rise) I understand that cash flow risk is increased because your swap net position will be negative and you will owe the difference between LIBOR and fixed rate (if interest rates rise)
B Market value risk–total value received decrease Cash flow risk–in many cases, I see this risk links with reinvestment risk. interest rate up, reinvestment risk down, cash flow risk down…
interest rate goes up then floating payment goes up and these payment are linked to interest rate and hence larger payment. Market value does opposite of cash flow. C
I agree with increasing interest rates your floating rate payment will increase thus increased cash flow risk, but wouldn’t this increase market value risk? You’re long a fixed-rate instrument and rates increase thus value decreases, so wouldn’t correct answer be A?
I am with sudndevl21… FM, would you mind posting the correct answer?
A – for fixed cash flows the PV of your cash flows change with interest rates (mkt value will decrease so mkt value risk has increased) and cash flow risk increases as floating payments will be higher now A fixed rate receiver is effectively long a fixed rate bond and short a floating rate bond, a positive duration position
C. But it really depends from what perspective you are looking at this. For hedging a fixed rate liability with pay floating swap the reason youd do this swap is because 1) you think rates will fall, and 2)you have fixed rate debt The swap basically turns your fixed rate debt into a floating rate debt and you are protected when the rates fall (you benefit by paying less) but unprotected if rates rise. since you are now making a floating payment, there is CF uncertainty as you dont know what you will pay next period. MV risk applies to the firm’s asset and liabilities only, and the addition of the swap has effectively lowered the duration of your liability because you now pay floating. The lower duration of the liability means less sensitivity to interest rate hence market value risk. or simply: pay floating swap makes floating pmt = higher CF risk but lower liability duration => less MV risk pay fixed swap makes fixed pmt = no CF risk but higher liability duration ==> more MV risk If you own a floating rate bond that pays a floating coupon, you would also enter into a pay floating/receive fixed swap to protect against a decline in rates. However, the swap turns your bond into a fixed rate coupon(lower CF risk) with higher duration, therefore more MV risk. This is kind of how I have it worked out in my mind, hope this is correct.
I think its A My reasoning: If your paying float, you don’t know what future CF will be so your Cash flow risk would increase since you have to give a higher rate with the rising interest rate. Your market value risk will increase since you receive float and the rising interest rate has effectively reduced the value of the fixed payments you receive.
Shanghaiexpo- I think you’re overthinking the problem and assuming too much. First, the problem never states that the swap is offsetting a fixed rate liability. Second, I agree that IF that were the case, the MV risk would decrease, but the problem asks what the interest rate effect is. In your example, the MV is effectively decreased solely by entering the swap and has nothing to do with a change in interest rates. Granted the original problem is a conglomeration of several and doesn’t appear to be verbatim from a practice exam, but at least that’s my take on the details. I really would like to see the answer posted though to end this speculation - also in terms of perspective I have been assuming that the “you” in the problem refers to “company A.” If that’s not true, shame on the question writer, borderline ethics violation in attempt to mislead…
I hate these fking posters who just run away after posting questions…
Sundevl21, maybe I’m over thinking it…it is very possible. Yes, the “you” would be the company holding the debt or bond. I think because there are two parts to the swap (paying floating, receiving fixed), it depends which angle you want to look at it, ie are you are trying to hedge a liability or asset. But youre right, the original post does not give enough info. Pupdawg82, look at Volume 2, exam 2 PM Q20.6 on pg 134. In the example, he is trying to convert the firm’s debt, I would imagine that the answer would be different from an investor’s perspective when trying to hedge bond positions. aight, im off…enjoy girls and boys…
I think the cat who posted this was just doing it to screw with us… look at his name… obviously he knew we would not figure it out because we are just low life CFA candidates… he is getting his MBA, therefore MBA is way better than CFA…
Hey guys, I’m pretty sure i’ve figured it out. The question come from Schweser Volume 2, Exam 2, Afternoon Q. 20.6 Market value risk refers to duration exposure. So in the original question, if you are long fixed and short floating, the swap has a positive duration for you and when interest rates go up you get hurt, market value risk increases. Cash flow risk refers to the certainty of receiving cash flows. If you are receiving fixed cash flows, cash flow risk is low for you. The correct answer is B
I dont get how CF risk reduces, when your CF changes. It doesn’t add up.