IRS Long/Short interpretation

Discussion in 'P1.T3. Financial Markets & Products (30%)' started by Turner737, Apr 17, 2012.

  1. Turner737

    Turner737 Member

    Tried to start this as a convo with you but it didnt work...In regards to IRS and obligations from our discussion on twitter..

    My teacher used an example of buying a coffin before you die so your family doesnt have to buy one(morbid I know). So the obligation is on the seller of the coffin who accepts the upfront payment for the obligation to deliver something in the future. The quoted price of the coffin is what the seller of the coffin receives(the short). Since IRS are quoted on the fixed rate side(thats key to me in understanding it) in my mind if I were to "buy" an IRS id be buying that quoted price(paying that fixed interest) and then someone is selling to me the "product" which is floating rate side. So while they are definitely both obligations for me understanding how it was quoted was the big part in understanding the long vs short interpretation. Because at least to my understanding the long pays the quoted price. Perhaps my intuition wouldnt apply to all situations but it makes sense to me in this scenario.
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  2. Matt, thanks that's pretty cool in my opinion ... it works for me, to think of the set of floating rate obligations as the coffin (er, product). I guess now that you frame it that way, we could also view the buyer (long) as long the floating rate (gaining if the floating rate goes up); ie, so the long in an IRS is long the rate. Well, i feel better, I honestly spent one hour searching references, not finding too much that is helpful

    ... also, not helping is the apparent error in example 30.5 of FRM handbook (page 764) which asks us to "Identify the risk in a fixed-income arbitrage strategy that takes long positions in interest rate swaps hedged with short positions in Treasuries." So, that looks to be mistaken as the hedge to a short Treasury (i.e., who loses when rates decrease) is a floating-rate payer (who gains when rates decrease) and therefore must be SHORT the interest rate swap. :confused:

    Thanks for the help, I hope you're studies are going well (I see your backlog questions, sorry, I am up against tough deadlines on the videos and mock exam)!
  3. Turner737

    Turner737 Member

    Exactly, thats how I viewed it with the buyer being long the floating rate. Although I can see how thats confusing since at its simplest its still just swapping payments.

    In regards to that example 30.5 is the risk exactly what you said? So the risk is that you arent really hedged by entering those positions you are in fact doubling down with having to pay a fixed rate on two different positions? Or is it an actual error where they really wanted one to interpret the risk of having a long IRS swap and long treasury or vice versa?

    I understand your busy with deadlines etc, i go through prior forum posts to see if any of my questions have been asked prior.
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  4. Hi Matt, In regard to FRM handbook 30.5, I think it's an error: it asks about a "long position in an interest rate swap" (I was trying to craft a similar question, is why i got confused ...) but the answer (p 775) includes, if swap rates decrease from 5.5% to 5.3%, then the "values for both the swap and the Treasury bond would increase" so this appears to imply a short in the IRS (in any case, a short IRS would hedge the short Treasury). Thanks!
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