Swaps question - Leveraged Floating Rate Note

CFA Level III
#1

From Reading 29. Sorry for the unfriendly notation, but it is quoted directly from CFAI text, p. 362 :

1 - Company issues Leveraged Floating Note : Principal = FP ; Pays Libor * 1.5

2 - Company takes proceeds and purchases Fixed Rate Bond with a face value of 1.5 * FP ; Pays Coupon = ci

Therefore the Company receives ci on Principal = 1.5 * FP, and pays 1.5 * Libor * FP

3 - Company enters into Swap on Notional = 1.5 FP, on which Company pays fixed rate of FS and receives Libor

This nets 1.5 * FP * (ci-FS) profit for the company, given that ci > FS.

So, how is the company issuing an amount of FP and buying an amount of 1.5 FP with the proceeds ?

Is it because the différence of 0.5 FP is leveraged ? If so, then where are the financing costs ? What am I missing here ?

Many thanks.

#2

I think we have to assume they’re financing the other 0.5FP or utilizing an existing source of capital on the balance sheet.

#3

Nope.It is clearly mentioned that the company isn’t commiting any capital…

#4

But I agree. Surely, they are financing it and just ‘‘forgot’’ to take interests into consideration. Otherwise they create money out of thin air.

#5

Which EOC/BB/Exhibit is that? I only have the ebooks and the page numbers are different.

#6

Exhibit 2

#7

This one is pure sleight of hand as far as the leverage goes. In this example, there is no actual FP amount involved; At every stage of the transaction all principal amounts are 1.5 FP.

*edited

#8

Not sure about that. The BB right after has the same issue,with 1 x FP and then 2 x FP.

#9

Also, if it is 1.5 FP everywhere, then just use ‘‘FP’’.

#10

This has been bothering me as well, the fact that it’s explicitly stated that there’s no capital committed is troubling. I’ve sat and tried to think this through and just had to give up. There has to be leverage and it’s just conveniently left out of the problem. In any case, I think if you can work through the transactions you’re probably set for the exam and any extra energy is probably better spent elsewhere.

#11

Yeah **** it. Just wanted to make sure that I wasn’t the only one wondering WTF.

#12

Hi guys,

I am bringing this topic up. It seems that it has been bothering candidates on this forum for years somehow. I was just trying to do the EOC and it bothered me as well. Does somebody have an answer for that? and otherwise, should we write to the CFA institute to get clarification?

Thanks