From Read 31. P454 on the topic of using swaps to create leveraged floating notes. The text says for an issuer of leveraged notes to make money and manage risks, the issuer would issue a leveraged floater with a principal of FP that pays 1.5X LIBOR. Then the issuer will buy a fixed rate bond with a face value of 1.5(FP) that pays a coupon of ci with the proceeds. Finanlly, the issuer will enter into a swap on a notional amount of 1.5(FP), pay the swap fixed rate of FS and receive a floating rate of LIBOR. All this nets out to 1.5(FP)(ci-FS). If ci>FS, the issuer makes bank. Then it goes on to say, the issuer assumes credit risk of the counterparties but put up no capital upfront…
I have a tiny problem with this. When the when the issuer issues the leveraged note with a face value of FP, and use the proceeds to buy a fixed rate bond with a face value of 1.5(FP), doesnt the issuer have to make up the .5 difference with leverage or his own capital? What am i missing here? Thanks.
Thanks cpk123, just to clarify, do you mean the issuer would get paid 1.5FP for the leveraged floater, which he would subsequently use to buy the fixed rate bond? The text is somewhat unclear on the mechanisms…
so if u’re shorting a leveraged floater with face value Fp that pays 1.5L, what am I actually receiving? Fp or 1.5Fp?
To hedge the 1.5L I’d have to enter a swap that has a NP of 1.5*Fp (receive float/pay fixed) by purchasing a fixed bond with 1.5Fp NP to be paid out of my pocket. The difference in pay fixed (from the swap) and receive fixed (from the fixed bond) is my arbitrage profit.
If I’m only receiving Fp for the leveraged floater and have to buy a 1.5Fp fixed bond, I’m sinking 0.5Fp this wouldn’t be an arbitrage. This is confusing.