Schweser practice V1 third afternoon, p195 Q47, it says since we SBK pay floating, it is subjected to cash flow risk, I’m a bit confused, in swap, either we pay floating or we pay fixed, so if we pay fix, do we have cash flow risk also? If it is true, can I say in any swap, we only have cash flow risk and no price risk?
Anyone can give a example of price risk (market risk) for swap?
In Q46 enertech case, it is mentioned that they long interest rate collar,
So if we buy interest rate floor and sell cap to finance it, is called as “ short
If you pay fixed , then you’re receivining floating. What if rates drop? Your income could reduce ., while your expenses stay the same That is cash floaw risk.
If you pay floating , then you may have to pay more if rates rise , while receiving prety much flat amount . That is cash flow risk.
Use common sense.
On the interest rate collar , the long collar is defined as buying a floor and selling a cap to finance the premium of the floor. So this is a lender’s perspective . He doesn’t want to get less than a minimu rate , ut is willing to give up the upside beyond a certain rate. So his profits are confined in the region between floor and cap.
If you do the opposite, i,e, take a short position in the collar ,i.e. sell the floor and buy a cap , your’e looking at the rates as a borrower . You are willing to give up the benefit of the decrase of rate beyond a point , in return for protection against high rates above a certain number . So your borrowing cost will be confiend to the range between floor and collar .
For 1 - there is market risk if you are the pay fixed, there is cash flow risk if you are the pay floating. The questions will generally be structured so that a company is trying to offset some bond they are currently paying on. if they are currently paying floating they have cash flow risk, but if they enter into a receive floating, pay fixed swap to offset the floating payments - then they no longer have cash flow risk, but have increased their market risk. this is because as interest rates rise, they wont have to pay more in interest anymore because they have offset that payment with the swap, but the market value of the swap will decrease - e.g. market value risk.