# Reading 38 Risk management Swaps EOC Question 2B

EOC Question 2B, for Reading 38 (Swaps) asks whether a 3 year swap or a 4 year swap should be preferred?

The current portfolio has duration 1.5. The objective is to increase the duration to 3.5. So, the duration should be increased by 2 from 1.5 to 3.5.

The correct answer according to me is that the 3 year swap should be preferred because the duration of 3 year swap is 2 as seen below.

Duration of 3 year semiannual payment swap = duration of Receive fixed - Duration of Pay Floating.

= (0.75 * 3) - (0.5 * 0.5) = 2.

Spot on.

Why does the book say that we should prefer 4 year swap, which increases the duration by 2.875.

P.

OK, sorry I should have waited till I read the response the Question 2C.

I guess, we prefer the 4 year swap because we can get away with less Notional principal as compared to a 3 year swap which would require more NP because of smaller duration.

Please correct me if I am wrong in my conclusion.

Regards

P

yes

anything lower would also require u to enter into the swap more # of times.

OK. Thank you both, Janakisri and CPK123.

CPK123 - You are saying more number of times, which in this particular instance translates to higher Notional Principal.

P

3 yr swap will have NP = \$ 100 mi

4 yr swap will have NP = \$69.56 mil

So 4 is preferred. I also did nt understand " anything lower would also require u to enter into the swap more # of timesâ€™?

cpk is correct . A 3 year hedge will need to be renewed because the desired duration is 3.5 . The 3 year bond will expire in 3 and you will need another bond thereafter.

Which means at least two transactions and transactions cost money ( commissions etc. )

So choice of swap will also be determined by its contract term. Should this alwyz be atleast equal or greater than the desired duration?

I thought it is determined by the Notional principal amount & net duration of the swap