CFAI text SS15 Reading 43 Problem no. 3

something, interest, solution

Hey guys,
I hope I’ve referred to the right reading. This is a problem in interest rate swaps.
In problem 3, it says that the the company has a floating rate obligation of $500m with a coupon payment of 2.5 times LIBOR. In the solution you will see that the NP is multiplied by 2.5! I’m confused! Anyone knows why?
Why multiply the entire face value by 2.5 when only the coupon payment is 2.5 times LIBOR?
Am I missing something? Please help!

WarrenB1

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2^#

发表于 2013-4-3 18:38 | 只看该作者

issues a leveraged floating-rate note
you pay: $5M*2.5*LIBOR ie. $12.5M*LIBOR
To offset the $12.5M*LIBOR, you enter into swap
The swap
You pay: 6% (fixed rate) on $12.5M
You receive: LIBOR on $12.5M
Net position (swap+leverage floating rate note issues)
=$12.5M(LIBOR-LIBOR-6%)
= you pay 6% on $12.5M
As you bought a bond
You receive: 7% on $12.5M
Overall Position:
= you pay 1% on $12.5M = $0.125M
= You enter a swap of 12.5M and not 5M because you receive LIBOR from swap only and not 2.5*LIBOR. To offset the 2.5*LIBOR, you increase the NP to 5*2.5 = $12.5M

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ohai