Got this Q wrong on the Schweser Mock. I’ve typed it below for all you guys who don’t have the exam. There is an analyst (Haswell) who pays a floating rate on a bond, and plans to enter into a payer swaption to hedge his risk because he forecasts interest rates rising. Then Q 39 reads as follows:
If Haswell’s interest rate forecasts prove correct and the appropriate hedge is enacted determine which of the following best describes the effect on Peterson’s cash flow risk and market value risk.
Cash Flow Risk Market Value Risk
A) Decreases Decreases
B) Decreases Increases
C) Increases Decreases
Answer is B. I put A. I know that cash flow risk decreases because he’s no longer paying float. In general, market value risk should increase because he pays fix. However, his interest rate forecast is rising rates. Rising rates are good for a fixed payer, as the MV of liabilities decreases. So doesn’t MV risk go down? Why is the answer not A?
Multinational firm based in the United States, planning to build a US factory which will take 2 - 3 years. Haswell (analyst) expects interest rates to rise. In previous 2Q, you had to choose that she needs a payer swaption and then calculate the payoff in 6 months.
You have a higher duration on the fixed rate loan … so Cash Flow risk reduces, but Market Value Risk increases.
EOC Summary:
When a floating-rate loan is converted to a fixed-rate loan, the resulting duration is that of a fixed-rate loan. The duration of a fixed-rate loan is normally much higher than that of a floating-rate loan, which has a duration relatively close to zero. Compared with a floating-rate loan, however, a fixed-rate loan has stable cash flows, which reduce cash flow risk, but has a much greater duration, which increases market value risk.
Agree with what you wrote. But the point is that higher interest rates are forecasted and the question even says to consider that the forecasts are correct.
Higher interest rates —> decreases MV of liability --> less MV risk
The higher duration on the liabilities because of the fixed pay position only serves to lessen the duration of the portfolio, which also decreases MV risk.
Why is it irrespective of the forecast? We are told in the Q to consider the forecast. The below is copied from Schweser Book 4 Page 232. To me, this sounds as if entering a fixed pay swap increases your liability duration, which decreases your market value risk:
Becauase fixed rate instruments have a longer duration than floating rate instruments, the addition of this pay-fixed, receive-floating swap has increased the duration of the firm’s liabilities and narrowed the difference between the asset and liabily durations. The bottom line is that the firm’s equity, with a shortened duration, is now less sensitive to changes in interest rates than before managerment enterd the swap. If rates rise, the value of the equity will fall less than before management used the swap. However, if rates fall, the value of the firm’s equity will rise less than before the swap. To protect against rising rates management has sacrificed some of the uspide potentioan from falling rates.
The forecast would represent a deterministic scenario and if the swap was evaluated on only a single scenario, there would be no cash flow or market value risk regardless of entering into a payer or receiver swap. As a result when assessing any type of risk we have to consider all possible “scenarios” or possibilities. This will lead you to answer stated in the key.
I though receiving fixed one had market risk, receiving floating, one had cash flow riks
Receiving fixed
Fixed - floating = greater duration
Rceeiving floating
foating - fixed= lower duration
How does your market value risk increase when you are paying out fixed? That is like someone else holding your fixed rate bond, and you receive floating, which is a cash flow risk. why don’t THEY have the market risk and you have the cash flow risk?
Alternatively, liek CP wa saying you could take a duration approach, but again receiving floating and paying fixed lowers duration.
how is it not C? You are risking not receiving the cash flows or them changing, but you arent exposed to market risk because your asset is a fixed rate note, not a floating one?
When a floating-rate loan is converted to a fixed-rate loan, the resulting duration is that of a fixed-rate loan. The duration of a fixed-rate loan is normally much higher than that of a floating-rate loan, which has a duration relatively close to zero. Compared with a floating-rate loan, however, a fixed-rate loan has stable cash flows, which reduce cash flow risk, but has a much greater duration, which increases market value risk l
LOAN would be to the receiver of the payment. I.e, I LOAN you money at a fixed rate, the LOAN is my asset, and yes my market risk is increased, but if I BORROW at fixed and RECEIVE floating,
Dont I have cash flow risk and the lender have the market risk?
You have to consider both the underlying instrument and the hedge, and the characteristics of the net position. In this case the instrument is a floating rate obligation that has no market value exposure, but significant cash flow risk exposure. By entering into a pay fixed recieve float swap, the individual is converting their floating rate obligation into a fixed rate obligation. As a result interest payments are fixed thus reducing cash flow risk, however if rates change, the FV of the obligation either increases or decreases due to changing discount rates.
When thinking about a swap, both the payer and reciever have MV AND CF risk. This is because both side bear the risks of the fixed and floating rate leg. The only difference is that you are long one end and short the other. So you can either be long the CF risk and short MV risk or long MV risk and short CF risk.
Looking at the pay fix leg our duration for a 4yr swap is .25 - 3 = -2.75, which is not a neutral duration (MV Risk) We pay varible rate cash flows and recieve fixed cash flows and the net is variable (CF Risk)
Looking at the recieve fix leg our duration is 3 - .25 = 2.75, which is not a neutral duration (MV Risk) We pay fixed rate cash flows and recieve variable rate cash flows and the net is still variable (CF Risk)
The only difference is in the example we now add the instrument, which has only “1 leg” pay variable, which cancels out the CF risk, but still leaves the MV risk.
Shouldn’t he have 0 market value risk? He is making fixed payments… why would he care about the value of that when he just makes the payments to expiration??
I thinks (market) risk means the value of Haswel equity (net asset) become volatility when he enters the swap as fixed payer or we think about deviation, which ralatively be constant before. Risk does not mean the asset will increase or decrease but both.
The market value concept is based on what a market participant would pay. In this case, the idea is that a fixed loan obligation is valued at par at inception; however as rates decline a fixed rate borrow would be now paying an above market rate and in today’s PV terms the liability increases in value beyond par. To the borrower nothing has contractually change, they will still pay the same rate, but the economic value has declined because market borrowing costs and discount rates are lower.
I undersant where you guys are coming from. The way i think of it, is regardless of which way the interest rates move, he will have market value risk. He has changed his liability to fixed. Yes, he is forecasting rising rates, and yes he may be right, but the new position is a fixed liability and therefore it has market value risk instead of cash flow risk regardless of his forecast.
Thats how I think of it, but I will agree it is a little tricky with that forecast thing thrown in there
you know what, i think you are right and i like the way you phrased it. we are all probably overthinking this way too much. fixed rate position has MV risk, floating rate position has CF risk. thats it. done.
sounds good to me. The only thing I would change, is Synthetic fixed rate position has MV risk, and synthetic floating has cf risk (just me personally, i get confused if i just think in terms of fixed and floating. Theres two sides of the fixed, the receiver and the payer, and the receiver is actually the synthetic floating payer etc)
But yea prob overthinking it, and i think its fair and right to say that if you convert your liability or asset to a fixed rate from floating, you now have mv risk intead of cf risk