JMI has issued a $12 million leveraged floater with semi-annual interest payments. The rate is 1.2 times LIBOR. The firm is planning to hedge the risk of this note with a bond paying 6 percent and a swap with a fixed rate of 4.4 percent. The net semi-annual cash flow is closest to: A) $115,200. B) $230,400. C) $96,000. please show your cal and explanation. Thanks!

i feel there something missing out here … JMI has a ‘pay floating’ obligation in first place. to hedge, he must take the ‘receive floating, pay fixed’ side. there’s no info on any receive floating leg of transaction. ???

B) 230,400 (0.06-0.044)*1.2*12,000,000 Just made it all up, no idea really

Its C for sure… $12 mio * [(6% - 4.4%)/2]

A. Its a leveraged floater so the swap and fixed bond cant have the same NP as the leveraged floater. it needs to be x up by 1.2. The swap will have a 14.4m NP with Libor on the one leg and fixed on the other of 4.4%. This libor will cancel with the leverage floater libor. leaving the two fixed rates of 6% and 4.4% on a NP of 14.4m. The annual receipt is 230,400. The semi-annual receipt is 115,200.

level3aspirant Wrote: ------------------------------------------------------- > i feel there something missing out here … JMI > has a ‘pay floating’ obligation in first place. > > to hedge, he must take the ‘receive floating, pay > fixed’ side. there’s no info on any receive > floating leg of transaction. ??? They have a floating obligation from the leverage floater. to fully hedge they purchase a swap but the fixed leg needs to be hedged as well with a fixed bond purchase. Not very well worded question really.

Thanks chedges…

semi-annual…rtfq

I say B…I have to draw out the diagram in my head as they have it in the text to remember how to do these, but here is the derivation: Leveraged Floater: -(1.2)(L)(12MM) Bond: +(1.2)(12MM)(.06) Swap: -(1.2)(12MM)(.044) +(1.2)(L)(12MM) Netting we get: (1.2)(12MM)(.06-.044) = $230,400 = B best, TheChad

semi-annual !

yeah, rtfq TheChad!

newsuper Wrote: ------------------------------------------------------- > yeah, rtfq TheChad! Hence the reason I will probably be repeating next year Best, TheChad

me too if I don’t follow my own advice

chedges Wrote: ------------------------------------------------------- > A. > > Its a leveraged floater so the swap and fixed bond > cant have the same NP as the leveraged floater. it > needs to be x up by 1.2. > > The swap will have a 14.4m NP with Libor on the > one leg and fixed on the other of 4.4%. This libor > will cancel with the leverage floater libor. > leaving the two fixed rates of 6% and 4.4% on a NP > of 14.4m. > > The annual receipt is 230,400. The semi-annual > receipt is 115,200. Excellent explanation. thanks.

Back to this question. How does this not require capital from JMI? They issue a 12MM bond but buy a 14.4MM bond. Where does the 2.4MM come from?

so they raise the 12mill then do a 14.4mill swap and buy 14.4mill worth of bond paying 6% annually? thanks

Yeah I dont get it. it says in the book that “no capital in required to engage in this transaction”. I dont see how that is possible. You issue bonds. You get 12MM cash. Now you need 14.4MM in bonds. You have 12MM in cash. Are the bonds are a deep discount? WTF?

maybe they used the 12mn to buy a leveraged fixed rate product…hahaha

A

Is A the final answer? Is this $12 million the notional principal?