I am working on a problem where company X entered into a 3 year semiannual interest rate swap paying fixed and receiving LIBOR. Notional is 150MM, fixed rate is 2.75%.
A year later the company is looking to neutralize risk since entering into the same type of Swap now costs about 2.3% fixed.
Strategy 1: is to short four off market LIBOR FRAs that coincide in the payment dates and Notional. This strategy will also neutralize the IR Swap.
Strategy 2: is to sell a floating rate note with a semiannual coupon based on the 180 day LIBOR, maturity of two years and notional of 150MM.
The problem is that the answer claims that the floating rate note will only offset half of the swap position. I’m failing to see this. By selling the floating rate note, the company is collecting some fixed payment from the counterparty and is obliged to make payments based on the 180 day LIBOR rate. Right now I’m failing to see how the floating rate note is not reversing the IR Swap.
I think it’s maybe that, while the floating rate note leaves you with LIBOR obligations that cancel out (because you’re paying and receiving), you still have a ‘pay fixed’ obligation from the original swap that you haven’t offset. Maybe if you invested the floating rate note proceeds into a fixed rate bond or something, (ie a situation where you receive fixed, which you could use to pay the fixed on the swap) then you would have offset both sides of the swap.
Yes, if the Floating Rate Note is indeed a one sided obligation, then I definitely see that the company would have to offset the ‘fixed’ portion of the original Swap. The thing is that I don’t see anywhere that describes the FRN as a one sided transacation, i.e. every financial transaction is two sided, I buy this in return for that.
So, to enter into a transaction where you sell an FRN, i.e. promise to make payments based on LIBOR (floating payments), what did you receive in return? nothing? I don’t think so. The counterparty must be paying you something in return. That something is the ‘other’ portion of the transaction and, from what I remember, would be the fixed portion. Again, I don’t see anywhere that typifies an FRN as a one-sided transaction. For example, wikipedia describes an FRN as a type of bond (buyer pays Price in return for coupons). If you guys have a credible resource that clearly describes the FRN as a one-sided instrument, please send it through. In that case, I’ll buy as many FRNs as possible…
A floating rate note is just like any vanilla bond. If you issue a $150m bond you get $150m in cash from the investors. You agree to pay them interest (at a floating rate) plus the principal at the end. You receive that cash (the principal) at the start but you don’t ‘receive’ any fixed rate payments. and seeing as you have to give the principal back, you’re left with nothing to offset the ‘pay fixed’ part of your swap. Like I said above, you could solve this by investing your floating-rate note proceeds in a fixed rate bond.