A LIBOR based floating rate bond combined with a LIBOR based zero cost collar (a long position in an interest rate cap and a short position in an interest rate floor both at a strike rate such that the collar has zero value) 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.
B? this is pretty close to a flat out guess. maybe not, since i thought about it for a while. i’m just not confident at all in my answer.
ewww. C?
The answer is B! But I’m not being able to picturize this thing. The LIBOR based bond should be looked at from the issuer’s stand point? Can you explain? Thanks a lot.
I’m guessing that was my problem - I was looking at the libor bond from the receiver side rather than paying a floating rate.
Ilvino, the question doesn’t really mention from whose standpoint we should be looking at this bond. Even I’m quite confused.
so from the issuers’s standpoint, the long position in the i-rate cap pays out if rates rise and exceed the predetermined rate, and the short position in the i-rate floor pays out if rates stay above a pre-set rate. So for the issuer, since he’s paying a floating rate, he doesn’t care if rates fall, but he wants to make sure rates don’t rise above a set rate. But I don’t see how that locks him into a “fixed” rate. I can see how he is protected from rising rates, but don’t see how his rate is fixed and known. Couldn’t the rate he is paying fall?
Ok. So you are the owner (not issuer) of a floating rate bond. you are being paid a floating rate. then you put on a collar, effectively “fixing” your floating rate payment. I thought that was pretty close to owning a fixed rate bond since you know what you’ll receive no matter what libor/floating rate does. what does the explanation say? am i off? i could have just gotten lucky.
ilvino, the short position in the i-rate floor means the issuer pays out when the rate falls below the floor rate. (not above). i just don’t understand this problem… cfasf1, can you explain a bit more? how is the “fixing” done? suppose i own the floating rate bond. So, I’m getting the floating rate payment; then i get paid when the rate rises above the strike rate (the cap will pay) and I don’t pay anything for the floor. Now, if the rate falls, the floating bond will again pay me that lowered rate; the cap doesn’t pay anything and i will need to make payment on the floor (since I’m short the interest rate floor). How does this transform into a fixed bond? Edit: The Schweser Explanation is useless. They have just re-stated the answer choice as an explanation.
very artificial problem. makes sense though …
ruhi22 Wrote: > cfasf1, can you explain a bit more? how is the > “fixing” done? suppose i own the floating rate > bond. So, I’m getting the floating rate payment; > then i get paid when the rate rises above the > strike rate (the cap will pay) and I don’t pay > anything for the floor. > How does this transform into a fixed bond? let’s say you have floor at 5%, ceiling at 7%, then your payment is max(5%, min(libor, 7%)) //always between floor and ceiling. since in our case floor = ceiling = 6% (for example). payment is max(6%, min(libor, 6%)) = 6% regardless of libor because floor = ceiling.
maratikus Wrote: ------------------------------------------------------- > very artificial problem. makes sense though … Do you mind explaining it to me? thanks.
maratikus Wrote: ------------------------------------------------------- > ruhi22 Wrote: > > cfasf1, can you explain a bit more? how is the > > “fixing” done? suppose i own the floating rate > > bond. So, I’m getting the floating rate > payment; > > then i get paid when the rate rises above the > > strike rate (the cap will pay) and I don’t pay > > anything for the floor. > > How does this transform into a fixed bond? > > let’s say you have floor at 5%, ceiling at 7%, > then your payment is max(5%, min(libor, 7%)) > //always between floor and ceiling. since in our > case floor = ceiling = 6% (for example). payment > is max(6%, min(libor, 6%)) = 6% regardless of > libor because floor = ceiling. makes sense. what about the floating rate bond? isn’t the payment from the floating rate bond still floating? thanks a lot for your help.
ok, let’s say the ceiling = 5% = floor. libor = 5.5% -> you pay 5.5% and get from ceiling 5.5%-5% = 0.5% -> you pay 5% libor = 4.5% -> you pay 4.5 % and pay floor 5%-4.5% = 0.5% -> you pay 5%
Cool! So this means that the floating rate bond need to be looked at from the issuer’s angle. I just wish the question was worded better. It would have solved all my problem…sigh. Thanks a lot for your help. Makes perfect sense.
I disagree unless the strikes of the floor and the ceiling are the same which is certainly not a requirement of a zero-cost collar.
yup. or the collar should have gone on short cap, long floor. right?
JoeyDVivre Wrote: ------------------------------------------------------- > I disagree unless the strikes of the floor and the > ceiling are the same which is certainly not a > requirement of a zero-cost collar. True. But the strike rate is the same here.
ruhi22 Wrote: ------------------------------------------------------- > maratikus Wrote: > -------------------------------------------------- > ----- > > very artificial problem. makes sense though > … > > Do you mind explaining it to me? thanks. You are borrowing money at a floating rate, but you are concerned about your exposure to the fluctuating rate. Therefore you go long (buy) an interest rate cap, so that if the rates go above a certain level the person who sold you the interest rate cap will make payments to you (therefore your rate hasn’t really exceed the cap)…but in order to pay the cost of acquiring the interest rate cap you go short (sell) an interest rate floor (you use the proceeds of selling the floor to buy the cap). By selling the interest rate floor you have agreed to pay the buyer of the floor if the floating rate goes below a certain level (thus you really aren’t benefiting from your own loan having a low rate. Now you’ve essentially converted your floating rate loan to act like a fixed rate bond, becuase if rates go above a certain level someone pays the overage and you have effectively maintained the rate; conversley if the rates go down you’ve agreed to pay someone else the under amount and you have effectively maintained closer to the original rate. It doesn’t matter what the floating rate is because you’ve contracted yourself into a window which will always contain your effective loan rate (in this case the window only contains the one value becuase the strike rate is the same for floor/cap).
this looks like an interesting although perhaps badly worded question… something i will make sure i absolutely understand near the exam is what is long a cap. what do that mean?? because it’s easy marks… to the one poster, i think we assume that “at a strike price” means it was the same for both ends… maratikus seems to have it right, but i think that assumes that you’re the issuer, whereas the cfa seems very investor-focussed… and could have been others before maratikus. and then someone owing the long bond would sell cap and buy a floor i.e. the opposite. can someone who’s taken exam before tell me if cfa exam questions are well-vetted to avoid these misunderstandings??? i haven’t taken a cfa exam for awhile. i’m someone heading back in, so to speak.