From the section on leveraged floaters: “KAT issues the leveraged floater, selling it to LifeCo Insurance with the intent of financing it with a fixed-rate bond and swapping the fixed rate for a floating rate to match the leveraged floater… Kat issues the floater, paying 1.5L ON FACE VALUE FP It then takes the proceeds and buys a fixed-rate bond issues by American Factories. This bond will have a face value 1.5(FP) and pay a coupon ci.” I feel like I’m missing something here. How do you finance the purchase of a bond with face value 1.5x with the proceeds from a bond for 1.0x? Do we have to assume that the interest rate offered by American Factories is sufficiently low that the quoted price will be exactly 1.0x on a bond with face value 1.5x?
This question has been asked and answered recently on this forum. Shouldn’t it be sufficiently HIGH, not low? Also depending on the duration ( say 40 year loan ) , 1.5 X face value for 1.0 X PV is not impossible , even for a lower YTM
I think they had it right. i low coupon paying fixed rate bond would be selling at more of a discount. of course, the poster called it an interest rate…instead of coupon. many things could make either the KAT issue sell at a premium and the AF bond sell at a discount, depending on the specifics around the issuer. (not just the coupon/interest rates). too little information to tell. so, i would just go with the facts and how to construct it…and assume no capital is required.
this is second time I am thinking more about this case and I have another example that (I hope) explains this: lets say there is no credit risk margin I issue a bond that pays 2xLibor, principal 100 PV(principal) = 70 PV(Libor coupons) = 30 PV(2xLibor coupons)=60 swap: exchange of fixed interest for floating interest PV(floating) = 30 = PV(Libor coupons) PV(fixed) = 30 I enter into 2xthis swap (200 notional amount equivalent) I buy bond, fixed rate, 2xprincipal of issued bond = 200 cash flow on trade date: I issue lev. floater bond at price 70 + 60 = 130 (receive) I buy fixed bond at par = 200 (pay) no cash flow on trade date on swap sum = +130 - 200 = -70 so I miss 70 how to finance this? I issue zero coupon, price 70, principal 100, and I believe this is the missing part of leveraged floater example in cfai
This note is not as complicated as this. It is as straightforward as it is in the curriculum… There is no need to issue a zero coupon bond anywhere. Just spend quality 15 - 20 mins to study is from the curriculum and the light will come on.
in the example in CFAI they do not explain anything about trade date (T0) cash flows. They are describing and calculating interest flows. This is what I see there. If you see more, me.tega, I would really appreciate if you explain it here, thks a lot. I understand that if we use different credit of issued and bought bonds, the numbers woould differ…