Not sure why, but I’m still not 100% on this one. Any help would be appreciated.
For a fixed income note, I understand that CF risk goes down (because the coupon payments are fixed) but the MV risk goes up (because its value is susceptible to changing interest rates). And for a floating rate note, the CF risk goes up (because the coupon payments potentially change each quarter) while its MV risk goes down (since its value is not susceptible to changes in interest rates).
So if you’re paying fixed and receiving floating… does your CF risk go up or down?? On the one hand you’re making fixed coupon payments (CF risk down) but receiving floating coupon payments (CF risk up). Or should we just be looking at this from the perspective of what we’re receiving – and not what we’re paying?? I’m confused :/.
normally it will offset a current risk ( if you are long fixed bond and go in a payer swap will offset your MV risk and expose you to CF risk only). IF you look at the swap alone, it will have both risk.
you can see it as being long a fixed bond and short a floating bond.
Viewed in isolation, if you enter into a fixed-for-floating swap, your cash-flow risk increases.
Viewed as part of your portfolio, your cash-flow risk may go down if the floating-rate cash flows of the swap offset floating-rate cash flows from another investment. For example, if you hold a floating-rate bond and you enter a pay-floating, receive-fixed swap, your cash flow risk decreases.
For the MV piece, you really need to think about from the POV of a company.
If I enter into a pay fixed swap, I have hedged the floating rate liability on my balance sheet, but I have added a fixed rate liability in the process. Changing interest rates will effect the MV of this liability. Because I am paying this fixed liability it has negative duration from my perspective. If interest rates decline then the MV of the liability increases as a result which can negatively impact my D/E ratios.