Leveraged Floating-Rate Notes

CFAI Reading 43, Volume 5, p.489. The text outlines how to make arbitrage-related, low risk profits, with no capital of your own using a leverage floater. Basically you issue a leveraged floater, then use the proceeds to buy a fixed rate bond, then swap your fixed payments for floating payments. If the fixed payments on the bond are greater than the fixed payments on the swap, you make money. My question is how do you do this without using any capital of your own??? When you issue the leveraged floater, you pay for example, Libor X 1.5 in coupon payments. To cover these payments you need to buy a bond with a face value of 1.5 X that of the leveraged floater you just issued. How would it be possible to buy this bond without putting up any of your own money?? Any ideas??? Thanks.

you buy this bond from the proceed raised from the floater.

Yes, but if you only issue the floater for face value X, but need to turn around and buy the bond for a face of 1.5X, how does that work? Example - issue a floater for 100 million paying Libor X 1.5, now you need to buy a bond bond with a face value of 150 million to cover the payments. How is it that you do this without putting up any of your own capital?

If You only need 100m to cover the floater. I haven’t seen the question but presumably you mean Libor +1.5 not Libor x 1.5? The Libor +1.5 is just the coupon on the bond, nothing to do with the par value. You would then enter a swap with the floating to match the Libor +1.5

No, I mean Libor X 1.5. For example if Libor is 5%, you have to pay 7.5% in coupon payments on the leveraged floater. If you turn around a buy a bond that pays fixed Libor, you would have to buy 1.5 times the face value of the leveraged floater you issued to receive enough in coupon income to cover your payments. My question is how you can buy additional face value without using your own money (the text says this can be done without using your own $$). Thanks.

You would never do that. Par values would have to match. It’s purely an interest rate play. You are thinking too much.

i remember last year i thought something was very, very wrong with either the text or the EOC question for these notes … can’t remember how it got resolved or if it’s even in the LOS. i don’t take the LOS wording seriously anymore except maybe where the topic isn’t even addressed.

You will match the par values and the floating values. The fixed price will determine the price if you remember from L2. The swap will have to perfectly match the floating on the coupon (which is Liborx1.5) and the par which is say 1. If the fixed coupon you pay on the swap is lower than the fixed coupon you receive from the fixed bond you have bought, then you make money.

HT2010, just to make you feel less lonely: I see the same problem as you do. Did you a find an explanation in the meantime? All the best, cmfranz