An individual with a floating rate obligation wants to convert it into a fixed rate obligation by entering into a pay-fixed swap.
The question talks about whether the cash flow risk and market value risk will reduce or not.
I understand that the cash flow risk will reduce because you have known payments to make. But why would market value risk increase? We are converting to a pay fixed swap which should reduce our duration and thereby the market value risk? Isn’t it?
The answer says market value risk will increase. I don’t understand how.
Fixed rate borrowings - no cash flow risk but have market value risk
Floating rate borrowings - no market value risk but has cash flow risk
Reason which fixed rate loan has higher market value risk:
Because as market interest rate goes up but given the fixed rate loan, then the market value of the loan has to drop to achieve the same higher market yield a borrower can obtain from the market. The opposite is also true when market rate of interest drop.
You’re correct if you’re talking about an asset, but here we’re talking about a liability. The liability goes from pay floating to pay fixed, which increases liability duration, and hence market value risk as rate changes will have a larger impact on liability value.
For example if you have a duration matching portfolio (asset) and want to decrease duration you could enter into a payer swap (pay fixed receive floating). A liability is effectively a negative asset hence the opposite: you increase the fixed payments.