TorkSpark currently has a $68 million bond outstanding that is not due to maturity until 2028. The coupon payments are fixed at 6.25% and paid quarterly. A decision was taken recently to try to reduce the interest rate risk on the bond. Which of the following positions is most likely to achieve the objective for the $68 million bond outstanding?
A. Pay fixed interest rate swap with quarterly settlement.
B. Pay floating interest rate swap with quarterly settlement.
The answer is B. But the bond holder wants to reduce the interest rate risk which means he expects the interest rate to increase. He should reduce bond duration. Therefore, he should enter a pay fixed receive floating swap. Why the answer is B?
I can’t think of any other solution than he has a bond liability?
Does it not explain in the answer?
you are paying out a fixed interest payment at 6.25%. Say interest rates are coming down in the market …
to handle that
you enter into a swap - where you receive fixed, pay floating.
the receive fixed cancels out the pay fixed part on the bond you originally had.
you now pay floating interest - and if interest rates are coming down - you have lower interest rate risk
but the counterpoint of that is -
a) if interest rates increases - you would end up paying a higher floating interest rate.
b) you are also now subject to higher market value risk - because interest rate down - your market value goes up.
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The explanation is he is looking to reduce the duration of the fixed rate bond. A paying floating and receive fixed is most likely to achieve this objective.
But is he a bond holder or bond issuer? That will lead to opposite answers. My understanding is he is a bond holder and expected interest rate to increase. Therefore, he wants to reduce the duration.