Hi all, this is a question from CFAI book 5 Reading 38 p.456 (swaps to manage risk of leveraged floating-rate notes).
I understand that when KAT issues leveraged floater to LifeCo, the principal amount KAT receives is FP with interest rate of 1.5Libor. KAT will use the proceeds to subsequently purchase the bond issued by American Factories with face value of 1.5FP and will receive interest rate of ci.
Last paragraph states that “KAT put up no capital to engage in this transaction”.
My question - KAT should put up some capital since the proceed that KAT receives is FP while KAT has to purchase a bond with face value 1.5FP. KAT has to take 0.5FP from its own pocket? Appreciate for any thoughts, thanks.
macted, you’re right. It’s fuzzy math unless American factories bonds of face value 1.5FP have a market price of FP. In real life, assuming American Factory bonds were selling at par; KAT would receive FP * (ci - 1.5FS) and will need to make sure that ci > 1.5FS. (In this case, the swap would work the same, with an NP of 1.5 FP)
S2000: here is the example from the book. Apologies for the cut-and-paste peculiarities.
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(Institute 456) Institute, CFA. Level III 2013 Volume 5 Alternative Investments, Risk Management, and the Application of Derivatives. John Wiley & Sons (P&T), 6/18/2012. .
FP is the par (face) value of the bond issued by KAT. But it’s paying 1.5 × LIBOR, so it will be selling at a premium. Exactly what that premium will be, I cannot say. There’s also no reason to assume that the the bond that KAT purchases will sell at par; it could sell at a discount.
Therefore, it’s perfectly reasonable that KAT could do this without investing any of its money.
S2000 - It says “KAT plans to issue a leveraged structured note with a principal of FP that pays an interest rate of 1.5Libor”, still does not make sense to me if KAT receives a premium in issuing this.
It then says “then takes the proceeds and buys fixed rate bond with face value 1.5(FP)”.
Even if it sells at premium, we then have to assume that the proceeds (which is at premium price) KAT receives is 1.5FP in order for KAT to purchase 1.5FP of American Factories’ bond.
If LIBOR is at, say, 4%, a floating-rate note issued at LIBOR pays 4% now and would be issued at (about) par. A floating-rate note paying 6% (= 1.5 × 4%) will be issued at a premium.
As for the American Factories’ bond, you’re assuming that because the par value is 1.5FP, it will be issued at 1.5FP; all I’m saying is that it may be issued at a discount.
Anything is possible, but it is not a good illustration for someone unfamiliar with the topic and trying to understand it. All these implicit assumptions need to be stated explicitly.
Maybe I am suffering from confirmation bias but overall, CFAI textbook material seems to lack any kind of peer review.
Thanks S2000 , I was being vague in understanding this one , but your explanation cleared up the mess in my mind.
Actually they never mention the proceeds from the issue or the cost of purchasing the bonds in terms of FP.
It was only my non-fixed income brain that was extrapolating face value to issue price somehow.
. price is of course set by ( mainly , and among other things ) discounted cash flows . So if the issue has yield of 1.5FP , it must be discounted appropriately ( i.e. huge amount ) .
And that can equate in price to a vanilla bond with a nominal yield ( i.e. prevailing fixed rate ) but face value of 1.5 FP . The face value is same but the discount is less ( lower yield ) , so the coupons are smaller.
And the swap can be used to equitize the cash flows , and generate the profit .
I actually had the same question. And even though I read your explanations, one thing is still unclear. Could you please look at the EOR questions and particularly the answer? There is a very similar probelm (Q3 I guess). The structured note has a Face Value of 5M USD. The bond, however, has a FV of 12,5M USD. So where does the sentence ‘put up no capital to engage in this transaction’ come into the picture? Do you think that the bond would be sold at such a discount? 0,4 of FV?
The discount to the face value would have to be pretty steep. The company from which the arbitrageur would be buying the note would be near default at such a price.
I believe that there is a potential misunderstanding here.
The 1.5(FP) is just to understand the formula. If you chose an arbitrary FP you would have to solve for ci which is not necessarily the coupon rate. What matters is the ci.
So if you use the same FP (in the example p.456) no extra money added to the proceeds received, your coupon is let’s say X your ci would be X/1.5.