Investment
XYZ investments is considering issuing a structured note
known as a bear floater to a client, ABC insurance. A bear floater is a
floating-rate note designed to allow an investor to profit from rising interest
rates. Thus, an investor in a bear floater would be bearish on bond prices.
Like an inverse floater, the bear floater can be issued as a stand-alone
security with its peculiar payoff characteristics. Unlike an inverse floater, a
bear floater pays an investor a high floating rate less a fixed rate.
The terms of the deal are as follows. XYZ investments will
pay ABC insurance 2 times one-year LIBOR less the current fixed rate, which is
6%, all based on the same notional principle (NP). The bear floater will have a
maturity of five years and settlement will occur every six months.
a) Using general notation, describe XYZ investments net
position after issuing the bear floater
b) If XYZ and ABC agree on a notional principle of $50
million and one-year LIBOR was 6% AT origination but LIBOR rises to 9% over the
following six months, How much will XYZ owe ABC when the first payment is due?
c) If current LIBOR is 7% how much would XYZ be prepared to
pay ABC if it decided to pay in advance rather than arrears?
d) What transaction would you recommend to XYZ investments
to hedge its position?
e) Given your recommendation, is XYZ completely hedged? That
is, will XYZ still have an exposure to rising interest rates and how would you
describe the overall position?
f) If XYZ decide to hedge its position it faces the risk
that LIBOR might fall below the fixed rate (ABC will not pay XYZ should this
happen). What interest rate option would you recommend to XYZ? What would you
recommend if XYZ does not hedge its position?
