Swaps & Structured notes

CFA Level III Derivatives
#1

In the section on using swaps to hedge structured notes the CFA text talks about a leveraged floater.

it says that you buy a corporate bond with face value of leverage x face of the structured note, but then goes on to say:

On the other hand, KAT put up no capital to engage in this transaction. The cost of the American Factories bond was financed by issuing the structured note. (Institute 366)

Institute, CFA. 2019 CFA Program Curriculum Level III Volume 5. CFA Institute, 5/2018. VitalBook file.

So I have 2 questions: is principal (face amount) paid at the end of a structured note, or is it just the “interest” cash flows with a notional amount?

how does the sale of the note cover the capital outflow of buying the bond? Say on a 50m structured note paying 2xLIBOR, you have to buy a 100m bond (presumably at close to par) but the inflow from the note sale will not be anywhere near 100m.

what am I missing?? Thanks!

#2

  1. KAT is SHORT/issues 50M (FS) => It pays 2LxFP - LifeCo

  2. It uses the proceeds ie 50M to LONG/purchases a bond that pays it 2xci (Bakra/scape goat/guy with credit risk)

  3. Engages in a PAY-FIXED (FS=Fixed rate) swap agreement with notional=2xFP, with a counterparty

So Principal cash flows net out between 1) and 2)

The arrangement results in the following period cash flows: -2LxFP + 2xFPxL- 2xFPxFS +FPx2xci = 2x50M(ci-FS) or 100M*(ci-FS)

  1. If ci>FS - KAT is rewarded cash less income, else…

  2. Moral of the story => ci-FS= Market price of Credit Risk Premium as the KAT is LONG the Credit Risk with Bakra haha

#3

Last year I e-mailed CFA Institute about this example.

Their response is that it is correct as written.

It isn’t.

For example, if LIBOR were flat at 4%, so that the floater pays an 8% (= 2 × 4%) coupon, a USD 1,000 par bond would sell at USD 1,038, which isn’t remotely enough to purchase a USD 2,000 fixed-rate bond no matter what the coupon rate. (Well, technically, that’s not true: you could buy a USD 2,000 par bond with a coupon rate of −46%, but that’s ridiculous.)

My advice: look over the periodic cash flow calculations and understand what they’re doing, and forget all about the rest of it. They’re not going to fix it, so you’re stuck with it.