Regarding Leveraged Floating Rate Notes (CFA Book 5, page 229): According to the explanation as I understand them: If a company issues a leveraged floater for 10M and pays 1.5 x Libor x notional pricipal, the company is supposed to buy bonds for 1.5 x notional principal from another entity, in this case 1.5 x 10M = 15M. Question: How is the difference between the principal obtained through the issuance and the principal for the purchase (here: 5M) financed? Can someone explain this to me / correct me? Thanks.
the multiple of the floater is like a hedge ratio…The libor you received from swap is fixed where floating payments are 1.5*Libor. So you can create the same effect by structuring the swap’s notional on 1.5 times floater’s principal.
itstoohot, thanks a lot for clarifying!
I don’t get it - particularly "The libor you received from swap is fixed ". Fixed LIBOR? Anyway buying bonds worth 1.5 M for 1 M is pretty easy. Your retail broker would finance such a purchase. Any decent treasury guy can get financing like that on any investment grade bond, and even many unrated bonds, and a whole bunch of bond like things. Heck, you can buy equity at more leverage than that in a retail brokerage account.
pays 1.5xLIBOR? do u mean 150 bps over libor?
You’re right JDV, the wording was terrible, it should be “hedged” instead of fixed…The case was: A company (KAT)issues a leveraged floater @ 1.5LIBOR and at the same enters a pay fixed receive floating swap. However, there is a mismatch between the LIBOR received from the swap and the interest paid on a floater (1.5LIBOR). The mismatch problem is solved by setting the swap’s notional 1.5 times leveraged floater’s principal. At the same time it buys another company’s bonds(American Factories) with the proceeds from leveraged floater issuance. Now KAT makes money only if the fixed swap rate it pays is lower than the interest on AF’s bonds (meaning it has a better credit). can we call it credit arbitrage???
Equity_research_nds – it almost seems to me that the CFA books mean it 1.5 times Libor –those payments are cancelled out for the floater issuer (through the swap), so that the term “1.5” seems important for the determination of the underlying principal. If we focus on the notional principal in the floater transaction and the bond investment (leaving the swap out): the proceeds from the floater seem to not cover the bond purchase, under certain scenarios there might be a substantial gap. JDV - You said that it would be easy to get it financed – but wouldn’t the floater issuer have to pay interest on this financing. Then, where are the costs of that financing subtracted from the profit of the floater issuer (or are they negligible?)? (CFA Book 5, page 229: KAT, the floater issuer, earns “1.5 (bond rate – swap rate) times notional principal” on the combined transactions) I mean the CFA material does not make a big thing of the reinvestment (so I don’t want to either); they only say that the issuer sells “the notes, using the proceeds to purchase a bond” and focus mainly on the swap.
Revisiting this reading too, specifically Question 2 B) pg. 270. The answer says the duration on a quarterly payment floater is 0.125 and the duration on a semi-annual payment floater is 0.25. How did they come up with these numbers???
- For the structured notes, notional of the swap is different (higher) than notional of the structured note, that is how they can “afford” 1.5 times LIBOR. They can do it because “they don´t do the swap with the notional they get from the structured note”… because at the begning of the swap, no notional is exchanged. OK, BUT THIS IS NOT PART OF THE CURRICULUM. I had a view, didn´t find in schwesser, and then I saw that this is not in the curriculum (structured notes and also using swaps to add/remove call options in bonds, or something like that). 2. UAECFA: They say that you only have interest rate risk in flaoting rate notes between reset dates. That duration is aprox (according to them), 50% of “tenor”. If you have semi-annual payments, time between reset dates is 0.5 (years). So 50% x 0.5 = 0.25 If time between reset dates is 0.25 (years, ie quarterly reseting), duration would be 50% x 0.25 = 0.125
Thanks hala, That makes sense. Still not sure why duration is only half of tenor but good enough answer for me!