An issuer of a leveraged floater ends up with a positive net cash flow each month. What does this say about the credit risk of a the “leveraged floater” issuer versus the credit risk of the long coupon bond component of the transaction.
Do you understand “leveraged floater” as having issued a coupon bond and a receive fixed interest rate swap or did I miss something in the books? The long coupon bond side (the counterparty to the issuer) has current and potential credit risk (on a stable basis) the (leveraged floater) issuer has current and potential credit risk. current credit risk because he currently receives net payments from his receiver swap and potential credit risk, as this could continue (no exchange of notional with IRS). If IR rise, he is only left with potential credit risk. As one note has the exchange of principal and the other not, and the above is usually with different counterparties, I would not assume you can make up a “net position” of credit risk as this would compare apples and oranges.
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A leveraged floater issuer has: A long position in a normal floating coupon bond (receiving 2f x Notional) + A short position in a leveraged floater paying lets say 2L x Notional + A swap receiving L x 2 x Notional and paying swap rate x 2 x Notional Net cash flow = 2 x Notional x (f - swap rate) Now, becasue the 3 positions are with 3 different counterparties, it is inappropriate to net the credit risk. A. The issuer faces credit risk from the normal bond issuer. B. The counterparty of the leveraged floater faces credit risk from its issuer C. Credit risk in the swap would vary in size and direction depending on the LIBOR term structure through the life of the swap
On second thoughts, just by looking at my final equation for Net cash flow one can tell that a +ve net cash flow means that the normal floating bond issuer is paying a spread over the prevailing swap rate and hence is a possible source of credit risk
The issuer of the inverse floater is also the swap fixed rate payer. If there is a positive net cash flow to the leveraged floater issuer, this means they are receiving more from the coupon bond than they are paying as a fixed rate on the swap. Therefore, we can infer that the credit risk of the coupon bond issuer (higher interest rate) is greater than that of the inverse floater issuer (lower fixed swap rate).
I believe the first sentence in your equation should be:
a *short* position in a *fixed* bond (receiving 2x fixed rate x notional) ?
Net cash flow = 2 x notional x (fixed rate - swap rate) ?
ignore first comment… I see now that it should be a Long Bond position. My guess is either floating or fixed would be OK since net CF is 2 x notional x (bond rate - swap rate)
can someone post final summary of correct transactions. Just to avoid ambiguity for future and current readers of this thread. Much appreciated.