Why is it not cash flow hedge bcoz exchange of interest amounts is considered to be as cash flows only then why are we are considering it here as liability?
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If he is concerned about rising interest rate then why he accept to receive fixed & pay float rate. How this swap position going to hedge its fixed income portfolio?
So basically I was also strangling with the same doubt. The conclusion which I got was the hedging is not about eliminating losses and risks but about reducing the exposure of the same. So here, if interest rates go up, the value of bonds in the portfolio will decrease as others in mkt. will seem more attractive due to higher coupon rate. Now, say we had 10million ka bonds in our portfolio and it got reduced to 9million due to int. Rates rising. And we’re facing 1million ka loss. Now if we enter an interest rate swap, the floating payments increase but the fixed rate in flows balances it out to some extent. Say we get, 700,000 as net inflow( fixed received – higher floating payed). The net loss is now 300,000 instead of 1million. So, the swap acted as a risk reduction tool here.
Interest rate swaps do not exchange cashflows rather it works on net -net basis. At initial both parties entering into swaps have non- profit positions, as interest rate rises upon the swap rate(fixed earlier), we have to pay higher float interest and we will receive fixed rate, but this happen on net basis. so, (higher float rate – fixed rate) the balance we have to pay to the float receiver. we do not have any cash inflow in this swap position.
Say fixed int. = 5% , and interest rises to say 7%, then in this situation as an fixed receiver we have to pay Net 2% interest on the notional principal to the float receive.
That is why I asked that doubt. We are losing on our portfolio’s value and at the same time on that fixed receive swap position(double lose).
If there is any other explanation to that or if there is any mistake in my explanation please reply and provide the correct solution.
Thank you.
You’re correct. But if we enter into a swap, the net loss gets somewhat compensated. Say before the loss would’ve been 1 million, now it will be 300,00..it kinds of offsets the losses by fixed rate still being received on the same price. If we had not entered the swap, pura 1 million ka loss hota and i get your doubt ki rate badhne se float rate jyada dena pad raha hai aur bond ka value bhi gir gaya hai. I had this same doubt. I did chat gpt, vahan se, i tried to understand. I am attaching the photo of that wait..
Here’s what chat gpt explained to me.
You’re right to point out the inconsistency, and I appreciate the opportunity to clarify. Let’s revisit the scenario step by step to ensure everything aligns correctly.
—
Situation Recap:
Tech Innovators Inc.** holds **fixed-rate corporate bonds**.
– Rising interest rates reduce the **market value** of fixed-rate bonds because newly issued bonds will offer higher rates, making the existing fixed-rate bonds less attractive.
– The company wants to hedge against the risk of declining bond values.
—
### Correct Hedging Position in the Swap:
To hedge this risk, **Tech Innovators should enter into an interest rate swap as a fixed-rate payer and floating-rate receiver**, not a fixed-rate receiver. Here’s why:
1. **Bond Portfolio Characteristics**:
– The company earns fixed-rate interest on its bond holdings.
– If interest rates rise, the value of these fixed-rate bonds falls.
2. **Impact of Entering as a Fixed-Rate Payer**:
– By paying fixed and receiving floating in a swap, the company offsets the risk associated with its bond portfolio.
– If rates rise, the floating payments they receive increase, which compensates for the decline in the bonds’ value.
– This effectively converts their fixed-rate exposure into floating-rate exposure, aligning with the hedging objective.
3. **Impact of Entering as a Fixed-Rate Receiver (Incorrect Choice)**:
– If the company were to receive fixed and pay floating, they would effectively double down on fixed-rate exposure, increasing their vulnerability to rising rates.
– This would worsen the risk rather than mitigate it.
—
### Final Clarification:
The company **must enter the swap as a fixed-rate payer and floating-rate receiver** to hedge the risk of rising interest rates. My earlier explanation contained a mistake in describing the position. Thank you for catching that!
Here’s one more break down by chat gpt.
Upon asking this question – if we go with the swap position provided in the example, would it somehow help to hedge or it is just incorrect?
The answer it gave –
Let’s carefully evaluate whether entering the swap position described in the example (as a **fixed-rate receiver and floating-rate payer**) would help hedge the risk.
—
### Example Scenario Recap:
– The company holds **fixed-rate corporate bonds** whose value decreases when **interest rates rise**.
– In the swap, the company is **receiving fixed rates** and **paying floating rates**.
—
### Will This Swap Position Help to Hedge?
1. **Swap Position Mechanics**:
– **Receiving fixed**: This adds additional exposure to fixed-rate interest income.
– **Paying floating**: This introduces exposure to floating-rate interest payments.
2. **Impact on the Hedge**:
– When **interest rates rise**:
– The value of the fixed-rate bond portfolio decreases.
– The fixed-rate leg of the swap provides a steady income stream, but it does **not offset the drop** in bond value because the bond and the swap are exposed to the same risk factor (rising rates).
– Meanwhile, the floating-rate payments the company must make will increase, further **amplifying the financial impact** of rising rates.
– When **interest rates fall**:
– The value of the bond portfolio increases.
– The fixed-rate leg of the swap becomes more valuable, potentially offering some benefit. However, this is not aligned with the goal of mitigating losses during rising rates.
3. **Conclusion**:
– This swap position does not effectively hedge against the risk of rising rates. In fact, it **increases exposure to fixed-rate risk**, making the company more vulnerable to interest rate increases.
– The correct position to hedge the risk would be to **pay fixed and receive floating**.
—
### Why It’s Incorrect:
– The position described in the example (receiving fixed, paying floating) is counterproductive for hedging a **fixed-rate bond portfolio** against rising rates.
– Instead, it would be suitable for hedging a portfolio of **floating-rate liabilities or investments** where the concern is falling rates, not rising rates.
—
### Final Assessment:
The swap position provided in the example is **incorrect for hedging the given risk** and would likely worsen the company’s financial exposure to rising interest rates. The correct hedge would be to **pay fixed and receive floating**.
It wont be a cash flow hedge position as by entering into swap agreement his portfolio is not being hedged rather its becoming speculative (more risk taken).
What are the options for it?
The answer is fair market hedge.