On risk management applications of swap strategies:
(p.216 of alternatives)
It talks about cash flow risk:
Cash flow risk is reduced by entering the swap because the uncertain future floating-rate payments on the liability are essentially converted to fixed payments that can be more easily planned for and budgeted, resulting in a reduction in cash flow risk. However, the low duration of the floating-rate liability is now converted to the higher duration of a fixed-rate liability. The liability market value will now fluctuate more as interest rates change. For example, if interest rates fall, the liability will rise in market value, creating a corresponding decline in the firm’s theoretical market value of equity.
Some argue that these changes in market value are unrealized, which is true. They are nonetheless real, and financial theory would clearly suggest they should affect that market value of the firm and of the equity. The swap reduces cash flow risk but increases market value risk.
I am not sure why the increased liability market value would lead to a decline in the firms market value of equity.
Also, why does it affect the market value of the firm itself? (If liability market value increases and equity market value declines, shouldn’t the overall firm market value be the same?)
convert floating rate liability to fixed rate liability, in a falling interest rate senario, interest payments should fall i.e. ur financing costs should drop but since ur payments as fixed, ur paying at a higher rate hence ur firm’s equity value will fall due to higher financing costs.
IMO they are unrealized as the costs of the fixed payment are already factored into the firm structure when the firm takes on the fixed rate debt. but since the rates are dynamic and equity value of the frm can change due to it, it is a real effect should investors’ or potential investors’ factor this into their decision to further invest in the firm. would u want to finance a firm with higher financing costs all else equal?? hence mkt value of the firm will be affected
Heres a simple scenario on how i think about it. A company issues a 5yr floating rate bond tied to the 10yr treasury, currently at 3%. They are afraid interest rates may increase and this will increase thier interest payements (higher cashflow risk) since they will adjust upward. To hedge this they enter into a swap so they pay a fixed 3%. Now if interest rates rise the value of the bond will drop or if interest rates fall the value of the bonds will rise. So they now have a fixed 3% bond after they enter into a swap, then interest rates drop to 2% causing the hypothectical fixed rate bond values to trade up to $110. The market value is now 10% greater than par. Now the company decides that they would like to be debt free so they decide to send out a tender offer to their bond holders to buy back all of the bonds at $110. They end up paying a price higher than Par or the initial liability level.