I have come across this type of question several times now and I am having a tough time wrapping my head around the concept: If you are long a Floating Rate Liability, and want to enter into a pay fix / receive float swap resulting in an overall net Pay Fix position, how does this increase the market risk of the FIRM given that the Pay Fix has a higher duration and is a liability? Does this not reduce the firms overall Duration as it is a higher duration Liability than the low duration Float? The Cashflow Risk is obvious, they now know ahead of time there payments. Thanks!
I saw someone else ask this as well - i think people are getting confused by the fact that you are long a floating rate liability and you are not long a bond. You essentially wrote a bond and are borrowing money and you have to make payments. The duration on that is most likely negative and you are making your overall duration even more negative by paying fixed and receiving float.
The farther your duration gets from 0 the more market risk you have.
I didn’t read this anywhere - this is just my conclusion from reasoning.
Someone please correct me if I’m wrong.
Reasoning this,
You’re long a floating rate liability
You enter in a pay fixed- receive floating swap
=>
You are in a pay fixed, i.e. you now have a liability where you pay fixed payments, ergo your market risk increased, movements in interest rates will affect you ability to repay the debt ( an decrease in interest rates is bad for you, cause you now are obligated to pay a fixed rate)
Thats my reasoning.
Jorge
Reasoning this,
You’re long a floating rate liability
You enter in a pay fixed- receive floating swap
=>
You are in a pay fixed (net the floating part), i.e. you now have a liability where you pay fixed payments, ergo your market risk increased, movements in interest rates will affect you ability to repay the debt ( an decrease in interest rates is bad for you, cause you now are obligated to pay a fixed rate)
Thats my reasoning.
Jorge
If you have a floating liab. in your books and the interest rate change the value is not affected so much = so market risk is lower
if you change it to a fixed liab. (with as you said using a swap) it will change more in value as interest rates change = higher market risk
so if interest decrease the your liabilites increase more in value and as we know euqity = assets - liab. so equity will become less.
I was thinking of this in the absolute terms of the fund and how it would affect the overall portfolio; but on an individual basis as you guys mention it seems to make sense. Thanks!
That’s how I remember it:
Floating loan --> Fixed loan, swap cash flow risk to market value risk.
Floating leg dutation: 50% of the payment of reset payment (0.25 for semi-annual payment) and for fixed its 75% of the payment period (say, 3* 0.75 =2.25 for 3-yr fixed payment) Much higher duration from fixed leg than floating leg so higher market risk