A LIBOR equivalent floating rate bond combined with a LIBOR based zero cost collar is equivalent to a: A) call option on a bond B) fixed-rate bond C) pay-fixed swap position D) floating rate bond with a different reference rate I had no clue, even with pretty diagrams. Can anyone help? Thanks
I would say B. You write a call, you take that premium and buy a put, zero cost to you (if the premiums are the same). Say you have a floating rate bond of 7%. You write a call at 7% and are long a put at 7%. Rates go to 8% = you receive 8% but pay 1% = 7% Rates go to 6% = you receive 6% plus a 1% gain on your long put = 7%
W did this one. They think it’s b, but it’s not.
Yes, answer is B. The crystal-clear explanation by my favorite answer provider is : “The effective rate above the cap strike and below the floor strike, when combined with the floating rate on a bond, is constant.” I definetely prefer Niblita’s explanation with figures. Thanks!
The problem with Niblita’s solution is that a zero-cost collar is not necessarily a collar with the same interest rate.
Joey, if you make a collar with different interest rates, would you need a portfolio of long and short puts and calls to offset the premiums received and the cost of going long at different rates?
I think in the Qbank there is the question, but it says that there is a long position in the collar. There would be no correct answer. long FR bond and short collar would be a fix pay bond, because the collar is equal to the floationg rate part of the FR Bond.
this question is total BS. its almost impossible to get a zero cost collar with the same strikes. it would be more likely like this: floating rate bond gives you 3month libor at 3%. you buy a floor at 2.8 and sell a cap to fund the floor at 3.1. this locks in a range from 2.8-3.1. thats the way it works.