1. For fixed-rate instruments, duration will be higher, since the change in incerest rates will change the present value of the fixed cash flows. 2, For floating-rate instruments, duration is close ro zero because the furure cash flows vary with incerest races, and the present value is fairly stable wich respect o changes in interest rates. For liquid instruments, the present value is the price. A “floating-rate” instrument can have a non-zero duration if ies next cash Flow has been set, which is the case with swaps (and caps and floors, t00). Since we know that the duration of a zero-coupon bond is its maturicy, che duration of the floating payments where the next payment is known, will be che time co che next payment. Ar inception or just after a sectlement for a quarterly reset swap, we estimace the duration of the floating payments as 0.25; for a semiannual reset swap che duration is 0.5; etc. For a pay-floating counxerparty in a swap, the duracion can be expressed as: Dpay Floating DFized — DFieacing Because he receives fixed cash flows, taking che receive-fixed/ pay-floating position in a swap increases the dollar duration of a fixed income portfolio. The modified duration of the portfolio will move an amount determined by (1) the relative values of the nocional principal of the swap and the portfolio's value and (2) relative values of the modified duration of the swap and char of the portfolio Professor's Note: Turning this statement around, we would expect the receive-floasing position £0 experience a fall in the fixed-income porsfalio duration. Example: Pay-Floating Swap Duration ‘Ac che inception of a ewo-year swap, the duration of the fixed payments is 1.1, and the duration of the floating payments is 0.25. What is the duration of the swap? Answer: ‘The duration of che swap is 1.1 - 0.25 = 0.85. For a manager of a portfolio of fixed income instruments who encers into this swap, interest-rate risk will increase (decrease) if the manager cakes the pay-floating (seceive-floating) side of the swap. Page 151Conversion of a Floating-Rate Loan to a Fixed-Rate Loan LOS 4.c: Explain, using duration, why the conversion of a floating-rate loan to a fixed-rate loan reduces the risk of cash flows but increases che risk of the market value for a borrower. ‘As explained already, a floating-rate cash flow will have a very low duration. This means the present value of the position is fairly stable, because it is the cash flows chae ceact ro changing aeerest rates, not their present values, A borrower may prefer the stability of the present value of the loan but must chen face the risk of variable future interest race payments. ‘As.we demonstrated earlier, a floating-rate borrower can convert a floating-rate loan to 2 fixed- race loan by taking the recelve-floacing side of a swap. The new synthetic fixed-rate loan (FRN plus receive-floating swap position) will change in value as interest rates change. ‘When a floating-rate borrower converts his/her loan to a fixed-rate with a swap, the risk aesociated with floating payments is removed. But the manager trades one risk for another because now the value of the synthetic fixed-rate Joan will rise and fall in value as incerest rates Aaland rise, Of course, what happens is that the value of the loan retains its stability, but the value of the receive-floacing/pay-fixed side of the swap will vary with changes in interest rates. / decline in interest rates increases the liabilicy of che borrower: FRN plus the reduced market value of swap duration Another way of stating this is ehac originally che floating rate borrower has a Habili “Close to zero. The receive-floating/pay-fixed swap has a negative duration because the duration of the floating side is less than the fixed side: Drei Floating Datestng ~ Drined <0 Hence, a decrease in interest rates actually decreases the present value of the swap. Thus, the foating rate borrower starts with 2 duracion close to zero and ends up with a nonzero duraor hich increases inceres¢ rate risk and the risk of the marker value for a borrower, Using Swaps to Change Duration LOS 4.d: Determine the notional principal on an interest rate swap necessary C0 change the duration of a fixed income portfolio to a desired level, Since portfolio duration is the weighted average of che durations in the portfolio, che no} principal of the swap determines the weight co apply to the swap's duration when recaleulacin the portfolio’s duration. Page 14, ‘ Page 152[As interest rates fall, the value of the receive-floating/pay-fixed swap position falls, so the duration of che receive-floating/ pay-fixed position will have a sign opposice to that of a fixed- income instrument, Also, because a swap will reflect expectations of fucure interest rares, the value of a swap ac inception is zero, Thus, adding 2 swap is a costless way co alter the durarion of a portfolio. ‘The following illustraces the offsetting effects: 7 interest rates = 4 value of fixed instruments + T value of pay-fixed swap position JL interest rates = T value of fixed instruments + 4 value of pay-fixed swap position The nexe question is, what are the swap properties chat are necessary to achieve a sarget duration for a given porrfolio? The answer is found in the following relationship: ) V(MD gee) © V(MDy )# NP(MD where: V_ = original value of the portfolio, MD, = modified duration of asset i, i= V, swap, target NP | = the notional principal of the swap Profesor’ Note: The manager weighs the porifolio and swap durations to achieve the rarges duration (i.e, the targes duration is a simple weighted average of the porefalio and swap durations). Usually, the portfolio manager selects a swap of a certain maturity which determines the modified duration of the swap, MDyyap- He then selecrs che NP chat will achieve the desired MD age: Rearranging, we can solve forthe amount of notional principal necessary co achieve the target duration: MDaagee - MDy w= eoftage22 ap Example: Determining the Notional Principal A manager of @ $60 million dollar fixed-income portfolio with duration of 5.2 wants to lower che duration to 4, The manager chooses a swap with a net duration of 3.1. Whar NP should the manager choose for the swap to achieve the target duration? i Page 153,