Using swaps with Floating Rate Notes

On page 489 of CFA text volume 5, they show an example where a trading firm, KAT, issues \$[FP]MM of floating rate notes to a life insurance company at a rate of 1.5xLIBOR, then apparently turns around and invests in American Factories by buying \$1.5x[FP]MM of American’s bonds. It seems then that there is a net capital outflow of 0.5x[FP] (i.e. they purchased 0.5[FP] more of American’s bonds than they issued to LifeCo) required to engage in this transaction, but the text insists that “KAT put up no capital to engange in this transaction.” How is this consistent?

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Purchase with leverage, just like lifeco is doing. Leverage than cancels out like interest streams. Only key in this example is adjusting swap notional, to effectively lock-in a spread.

KAT issues a leveraged floater with the investor being LifeCo Ins. So it will get an amount of FP. It buys ( or invests in ) a bond issued by American Factories paying fixed coupon of ci , but the face value of the bond is 1.5 FP . Remember that the price of the bond depends on coupon and face value is just the notional amount . The price of the bond will reflect coupon AND face value If you find that mind-boggling , just use a silly example of TVM: N=5, PV=1000 , I/Y=12 , FV= -1000. CPT PMT= -120 ( this is the coupon = 12%) Now PV = 1000 and FV= -1500 ( which is a face value of 1.5 x ) , I/Y is same at 12%. Coupon becomes -41.295 \$ at 12% I/Y. So you have converted x principle , y interest to 1.5 x principle and 41.295/120 y coupon. Just less coupon for more face value . In other words American Factories is getting less money up front than they will pay at redemption in return for much lower coupon

So are you saying that the bond KAT buys from American Factories is purchased at a 33% discount to face value, or that the leveraged floater it sold to LifeCo would be sold at a 50% premium to face value? I guess I never considered the possibility of a bond discount/premium becuase it seems like kind of a big leap for CFAI not to have explained in the example. Maybe I shouldn’t think too hard about this and just remember the way CFA presents the situation in the text.

Nice example, but doesn’t work here just because it would influence the swap. Bonds with prem or discount have off-market coupons, while a swap vs libor flat exactly pays market rate. In your example coupon is below market which you pay to swap ccp. Swap ccp in turn could now only quote libor minus something or you would give em an upfront payment, which corrects for off-market coupon to make it again libor flat (what you need in CFAI example). So here again you need cash:) Make things simple here because scope of the example is not what we are discussing: you give away leverage to lifco and pick it up again via american, your broker or whatever…as long as funding rates are equal the example works.