2002 #10

[Sifto]

I have a hypothetical question. I was wondering why the company has to sell the cap when it can enjoy positive cash flows when LIBOR>12%. The answer would be that selling the cap will reduce the net premium of purchasing the floor and thus, reduce the overall interest cost.

However, LIBOR only needs to exceed 12.16% in order for the gain from positive cash flows to offset the higher overall interest cost. Of course, LIBOR may not be greater than 12.16% in which case the company would be paying a high interest cost when it couldve sold a cap and reduced the premium.

If a LIBOR>12.16% is strongly expected, is it fair to say that the company would be better off only purchasing the floor and not selling the cap?

In an exam, I guess we have no reason to make interest rate expectations when devising a strategy but this may not be the case in practice.

This is analogous to justifying a simple collar. The advantage would be a lower premium compared to a pure cap strategy when interest rates are high but the "cost" would be higher expense when interest rates are low (since selling a floor). If you expect low interest rates, then a collar makes little sense. Correct?

[Kenny]

Exam problems are designed to test specific concepts and the assumptions and scenarios provided are not examined from all aspects to determine if they would make reasonable deals in the real world.

[Dr T Non-Fan]

Caps, collars, and floors don't make too much sense when isolated from the company's other cash flows. When isolated, they seem more like gambling propositions.

[JJ_Franch]

Can we discuss this question a little more. Ever since Reflection asked about it I've been doing circles. Here is the latest: Are we sure we need to sell cap and buy floor? Here are the 3 scenarios I - LIBOR<7%, II - 7%<LIBOR<12% and III LIBOR>12%.
--------------I---------------II-------------III
Product------7.5%-------LIBOR+0.5%------12.5%
Swap---(-LIBOR+8.75)--(-LIBOR+8.75)---(-LIBOR+8.75)
Cap-----------0--------------0----------(LIBOR-12%)
Floor----(-7%+LIBOR)---------0--------------0
Total--------9.25%---------9.25%----------9.25%

This seems to indicate: We enter the swap- pay floating get fixed. Buy a cap to match the cap of the product -0.5% and sell a floor, doesn't it??? Is the solution wrong- sell cap and buy floor?

Any help will be appreciated. I've already spet a way too much on this problem.

[nan shan]

Originally Posted by JJ_Franch

Can we discuss this question a little more. Ever since Reflection asked about it I've been doing circles. Here is the latest: Are we sure we need to sell cap and buy floor? Here are the 3 scenarios I - LIBOR<7%, II - 7%<LIBOR<12% and III LIBOR>12%.
--------------I---------------II-------------III
Product------7.5%-------LIBOR+0.5%------12.5%
Swap---(-LIBOR+8.75)--(-LIBOR+8.75)---(-LIBOR+8.75)
Cap-----------0--------------0----------(LIBOR-12%)
Floor----(-7%+LIBOR)---------0--------------0
Total--------9.25%---------9.25%----------9.25%

This seems to indicate: We enter the swap- pay floating get fixed. Buy a cap to match the cap of the product -0.5% and sell a floor, doesn't it??? Is the solution wrong- sell cap and buy floor?

Any help will be appreciated. I've already spet a way too much on this problem.

Actually, I use the same analysis as you to solve it. I can't figure out the SOA's answer.

[marciomp]

I have a hypothetical question. I was wondering why the company has to sell the cap when it can enjoy positive cash flows when LIBOR>12%. The answer would be that selling the cap will reduce the net premium of purchasing the floor and thus, reduce the overall interest cost.

The question says that "The CFO intends to use derivative instuments to convert this collared floater into synthetic fixed-rate funding". If you don't sell the cap, you don't have a fixed-rate instrument.

Can we discuss this question a little more. Ever since Reflection asked about it I've been doing circles. Here is the latest: Are we sure we need to sell cap and buy floor? Here are the 3 scenarios I - LIBOR<7%, II - 7%<LIBOR<12% and III LIBOR>12%.
--------------I---------------II-------------III
Product------7.5%-------LIBOR+0.5%------12.5%
Swap---(-LIBOR+8.75)--(-LIBOR+8.75)---(-LIBOR+8.75)
Cap-----------0--------------0----------(LIBOR-12%)
Floor----(-7%+LIBOR)---------0--------------0
Total--------9.25%---------9.25%----------9.25%

Your reasoning is right, but the conclusion is wrong.
According to your "Product" row, you pay 12.5% in scenario III.
According to your "Cap" row, you also PAY LIBOR-12% (since LIBOR>12%) in scenario III. Since you are paying it, it means you are short a cap.

[Dr T Non-Fan]

JJ, I think you have it completely backward (which is better than some of it backward, actually). Instead of purchasing/selling/entering swaps, caps and floors that look just like this product, you want to purchase/sell/enter swaps, caps and floors so that they COMBINED WITH the product (on the company ledgers) result in a fixed-rate security.

1. The "innovative floater" being offered to customers pays them (from us) the floating rate. The expectation is that we receive some fixed rate for this.

2. CFO wants to fund this using swaps, caps, and floors, in order to determine what the company should receive in a fixed rate from the product (which is not noted in the problem). This will result in 0 interest rate risk for the product combined with the swap/cap/floor.

3. So, in order to convert this into a fixed funded arrangement, you enter a swap agreement in which you pay fixed and receive a float. You always get the worst of the bid/ask (I can never remember which is which, just this fact), so you pay the higher one and you receive the lower one. So you'll pay 8.75% and receive floating. This takes care of the floating part of the innovative product.

4. You must now concern yourself with the possibility that interest rates drop below the floor. Purchase a floor at 7.0% for 0.90% of notional value. (Note that you'll pay a minimum 7.5%, but that will occur when LIBOR is at 7.0%.)

5. The product is still not fully fixed, as you will receive from the swap when interest rates are above the product's cap. So, sell a cap at 12% for 0.65% of notional amount. (Note that you pay LIBOR +0.50%, so when LIBOR > 12%, you pay only 12.5%.)

6. This makes the fixed rate of the product = 8.75% + 0.90% - 0.65% + 0.50% (remember: product pays LIBOR +0.50%) = 9.5%.

7. Sifto, you don't HAVE to sell the cap, but then you're not answering the question to convert the innovative product into synthetic fixed-rate funding. (Part (a) of question.) Is that a prudent thing to do during an exam?

8. Parts (b) and (d) of this question are likely worth more than the others.

9. Also, a chart, properly presented, will help the grader understand what you know. (Having four colors of pens might be considered showing off, though.)

I hope this explains it better.

[Dr T Non-Fan]

Another quick way to look at it is that you are NOT the customer trying to figure out how to create this offered product using swaps/caps/floors.

You are part of the company that wants to offer the product, but does not want the interest-rate risk associated with it.

[JJ_Franch]

Originally Posted by marciomp

Your reasoning is right, but the conclusion is wrong.
According to your "Product" row, you pay 12.5% in scenario III.
According to your "Cap" row, you also PAY LIBOR-12% (since LIBOR>12%) in scenario III. Since you are paying it, it means you are short a cap.

So, basically what you saying is: All Cash Flows have opposite signs and the swap is pay fixed receive LIBOR. That would make a lot of sense. I cannot believe I butchered another swap question (and it wasn't really currency swap eather)! I'm starting to question my understanding!

[JJ_Franch]

Originally Posted by Dr T Non-Fan

JJ, I think you have it completely backward (which is better than some of it backward, actually).

Go you get points for that

Thank guys! Going back to review some more floater crap