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) pay-fixed swap position. C) fixed-rate bond. Your answer: A was incorrect. The correct answer was C) fixed-rate bond. The effective rate above the cap strike and below the floor strike, when combined with the floating rate on a bond, is constant. (Study Session 17, LOS 64.b) i can see that if you combine a floating bond with a collar the floating rate will stay within the collar, but how is it fixed? say the collar is from 4% to 8%, you will still get movement between 4 and 8 wont you?
^Looks like kind of pegged in that narrow range of 4% to 8%, not exactly fixed (which is a point-value and not a range)
This question must be referring from the issuer perspective. Since the strike rate is the same for both long cap and short floor, it should translate into issuing a fixed rate coupon bond. If the floating rate goes above the strike rate, profit from cap would offset the loss from increase in floating rate. If the floating rate goes below the strike rate, loss from floor would offset with the decrease in floating rate, effectively creating a fixed rate bond.
apnesapne^2 Wrote: ------------------------------------------------------- > This question must be referring from the issuer > perspective. Since the strike rate is the same for > both long cap and short floor, it should translate > into issuing a fixed rate coupon bond. > > If the floating rate goes above the strike rate, > profit from cap would offset the loss from > increase in floating rate. > > If the floating rate goes below the strike rate, > loss from floor would offset with the decrease in > floating rate, effectively creating a fixed rate > bond. Perfect… nice explanation…
Correct - from the issuers perspective, it becomes a fixed bond, because the zero-cost collar “makes-whole” the deficit/sruplus coupon payments due to LIBOR volitility.
Thanks for the clarification! I was thinking the same thingZ!
can you explain this a little further, for some reason its still not sinking in? say you had a collar from 4% to 8%, where would the (same for both) strike rate be? inside the collar? also, how exactly does it create a fixed rate bond–is the fixed rate the strike rate? a short example may be very helpful
I think your confusion is coming from thinking the collar is always a range . In this case, there is no range. There is a fixed strike rate (let’s say 5%) for both cap and floor. So, if the floating rate goes above 5%, let’s say to 6%, the long cap position would have a profit of 1% times notional, but you have to forego that 1% profit on the floating rate bond issued, to have an effective rate of 5% to be paid off on the bond. Now, on the other side, if the floating rate has gone down to 4%, the bond would only pay 4%, but the short position on the floor with strike rate of 5% is at loss of 1% times notional. So the issuer again paid 5% in total. Hope this clarifies.
I don’t think that’s necessarily true, “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” I don’t think you could find a cap and floor whereby the floor’s premium would pay for the cap to make it a zero cost collar if interest rates are the same. I would think there will be a spread in interest rates…
apnesapne^2, thanks for the great explanation. it makes sense now. basically you “lock in” at the strike rate (identical for both cap and floor) so your floating rate bond may deviate but any increases or decreases are completely offset, making you effectively pay a fixed rate (at the strike rate). ali man, are you sure? i certainly do not want to argue with your statement, because it seems odd to have a collar where you just have one interest rate rather than a range; however, apnesapne^2’s explanation does make sense and his reasoning does give the right answer.