“swap reduces cash flow risk but increases MV risk”, but for which party?
so if i’m paying floating but i use a swap to switch to paying fixed, i guess that reduces cash flow risk. but what about the counterpartY?
Paying the fixed side of a swap reduces cash flow risk since the payments are stable and known. Compared to floating-rate payments, fixed-rate payments have a higher duration, which increases market risk.
The counterparty is just the other side of the agreement. If you flip it to the other side, the counterparty would be paying the floating-rate. Duration is lower for floating-rate payments, so market risk is reduced; cash flows may fluctuate so there would be more cash flow risk.
This statement isn’t true.
Period.
With all due respect, this is completely wrong.
Swaps are a zero-sum game. By themselves, they cannot increase the uncertainty of cash flows for one party and not the other; if my payment of cash to / receipt of cash from you is uncertain, then your receipt of cash from / payment of cash to me is exactly as uncertain. By themselves, they increase the uncertainty of cash flows for both parties . . . equally.
The same is true for market value risk: one party is long duration while the other is short duration, but the magnitude of those durations – hence, the market value uncertainty – is exactly the same. By themselves, they increase the market value risk for both parties . . . equally.
It’s only in combination with other securities in your portfolio that a swap can reduce cash flow risk, or reduce market value risk. Furthermore, depending the other securities in your portfolio, pay fixed / receive floating could increase your cash flow risk and decrease your market value risk, or it could decrease your cash flow risk and increase your market value risk. Similarly for receive fixed / pay floating.
Yes that’s what they meant: if I have a floating rate debt, I don’t really know how much interest I will pay next year. If I want to reduce this CF risk, I can enter into a pay fixed receive floating swap (with the same underlying of course, e.g. LIBOR 6m). By doing so, the cash inflow from the floating leg matches my floating debt interest payment. I just have to pay the fixed leg now.
Also, the swap has increased my MV value risk because if rates go down, the value of the fixed leg will go up and the floating leg will go down, thus increasing my liabilities.
That’s correct. But the point is that you have floating rate debt; that’s why receiving a floating rate will reduce your cash flow risk.