If interest rates fall the value of the pay-fixed side increases, right? i.e. it is either a large asset or a large liability. If so, can anyone explain further Schweser’s answer to Q5 p207 Book 4 which seems to imply the opposite. Thanks
int rates fall… you as a fixed rate payer are locked in paying a higher than market rate… value falls
In sense that you have a larger liability? If so, that is very poorly worded question. As the value to the counter-party quite clearly increases.
its a perfectly worded question. what are you getting confused about ?
maybe this will help … if you were in the market, in a declining interest rate environment, would you pay the same $amount for the current payer swap or a new payer swap? which one is worth more to you? or you could switch the swaps into options and still ask the same question…
Thanks for the help. I’ll try to explain what I’m saying. Let’s suppose we take out a swap, at the point of inception the value of the swap is 0. The value of each side is calculated by discounting the future cash flows at the appropriate discount rate. Let’s suppose each side is worth $10m at inception. The next day interest rates decrease. The pay-floating side is still worth $10m (ignoring the first payment), but the pay fixed side is worth MORE than $10m because you now discount the future cash flows at a lower rate. The pay-fixed party now has a liability, the pay-floating now has an asset. If I were to have to say what has happened to the value I would it has gone up. In the same way as I would with bonds: interest rates down, prices up. Now, are you all saying, the value has gone down because the pay-fixed has a liability? The question does not mention which party should be consider.
you are almost there with answering your own question … if you were the PAYER of fixed amount and receiving less $amount from the floating leg; and interest is declining… you have a liability (not an asset) . .the payoff is a higher liability to YOU. the value would be a lot higher To YOU (ie worth more to YOU) if you were the receiver fixed … getting it?
TheBigBean Wrote: ------------------------------------------------------- > The next day interest rates decrease. The > pay-floating side is still worth $10m (ignoring > the first payment), I think the PV of the floating payments will decrease. Note that due to drop in interest rates, the anticipated future payments are actually decreased. Even though using a smaller discount rate, the resulting PV should be less than $10m. Hence float-receiver will have reduced swap value in his book. > but the pay fixed side is > worth MORE than $10m because you now discount the > future cash flows at a lower rate. > > The pay-fixed party now has a liability, the > pay-floating now has an asset. If I were to have > to say what has happened to the value I would it > has gone up. In the same way as I would with > bonds: interest rates down, prices up. > > Now, are you all saying, the value has gone down > because the pay-fixed has a liability? The fixed-payer has an asset which is reduced much more than his liability is reduced. So the total value becomes negative (PV becomes -ve) - sticky > The > question does not mention which party should be > consider.
Thanks guys for you help. I think I’ve got it now! I was just looking at the question in the wrong way. The Edge - thinking about the receiver fixed position makes it much clearer. Thanks. Sticky - good point on the PV of floating rate side. That might be helpful somewhere else. Thanks.
no worries. If you have Don Chance’s book, practice problem 4 on p.292 should demonstrate this as well. - sticky