The bond portfolio has duration of 5, market value of 20 million, the question wants to change the target duration to 3. There are two swaps to choose from, one is 3 year, the other is 3.5 years. Which swap should I choose ?
the higher one will mean you have
a) to be responsible for a lower NP amount
b) that you would have to turn over your swap fewer times.
It seems I can choose either one, the CFA answer chose the higher one.
the reason is given above … you have a lower NP with the higher duration bond. Also if you were buying the swap for a multiperiod timeframe - then you would have to (notionally) shell out this NP amount fewer times (since the swap is applicable for in this case 3.5 years vs. 3 years for the lower duration swap).
For a treatment and discussion regarding this … read the text (on my 2014 book Pg 452 section starting …
These different durations affect the notional principal required, which leads us to the third question. Prior to the duration adjustment, the portfolio consists of $500 million at a duration of 6.75. QAM then adds a position in a swap with a notional principal of NP and a modifie
(and into the next page where they compare two swaps with different durations).
I found it, on page 359 of 2016 book. Basically, CFA prefers to use longer year swap to reduce the notional principal. Thank you !
Haha. The entire answer was given by CPK. Did you read it?