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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?

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Solution Preview

a) Since the bear floater is a swap, it is priced at 0 at inception. In other words, given the current LIBOR curve, the fixed rate of 6% was selected so as to make the current swap value 0. Therefore the position of both XYZ Investments and ABC Insurance is 0 at the inception of the swap.

b) Since payments on swaps are in arrears, the LIBOR rate at the six-month point does not affect the payment made at the six-month point (it affects the next payment). The first payment, which occurs at the six-month point, is

(2*6% - 6%)*50mm*(1/2) = $1.5mm

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Solution Summary

Hedging is assessed in the solution.

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