Which of the following positions results in synthetically issuing floating-rate debt? A) A long position in a fixed-rate bond combined with a pay-fixed interest rate swap. B) A short position in a fixed-rate bond combined with a receive-fixed interest rate swap. C) A long position in a fixed-rate bond combined with a receive-fixed interest rate swap. position in a fixed-rate bond combined with a receive-fixed interest rate swap. This is a question from Schweser Qbank. Could someone kindly explain what the concept of ‘synthetically’ issuing a bond means? I am failing to understand the concept and the reason why B is considered the correct answer in this question. Thank you all.
You should recall synthetic securities from Level I: they were discussed under the rubric of Put-Call Parity.
A synthetic security has the investment characteristics of the real security, but it isn’t the real security. For example, you can create a synthetic share of stock by buying a (European) call option on that stock, selling a (European) put option on that stock (with the same strike price and expiration as the call option), and buying a risk-free bond (with par value equal to the strike price on the options, and maturity equal to the expiration of the options). You don’t own any stock, but you own a portfolio that will behave exactly as if you did own the stock from now until the expiration/maturity.
What are the investment characteristics of issuing floating-rate debt? Ignoring transactions costs:
- You have a cash inflow today equal to the market value of the debt
- You have periodic cash outflows based on a given floating rate (possibly plus a spread)
- At maturity you have a cash outflow equal to the par value of the debt.
Look at the cash flows of the portfolios in A), B), and C). Which one duplicates these cash flows? That one’s the correct answer.
S2000magician. many thanks for this detailed and perfect insight. I most appreciate it.
My pleasure.