zero cost collar Q option, correct, position, interest, equivalent

grharmeyer

Any takers to help explain the rationale here for C? Their answer is not clicking...





A LIBOR based floating rate bond combined with a LIBOR based zero cost collar (a long position in an interest rate cap and a short position in an interest rate floor both at a strike rate such that the collar has zero value) is equivalent to a:

A) call option on a bond.

B) pay-fixed swap position.

C) fixed-rate bond.







Your answer: B was incorrect. The correct answer was C) fixed-rate bond.

The effective rate above the cap strike and below the floor strike, when combined with the floating rate on a bond, is constant. (Study Session 17, LOS 62.b)

huangxiaoxie

Hey guys--due to being short on time I've only skimmed the responses above, but taking a second look at the Q I now believe this is the rationale. Please let me know if this makes sense.


You are told that you are long cap and short call. This implies that you are short the floating rate bond. Why? If you are short the floating rate bond (automatically think interest rates), you want rates to go down. Thus, you fear rates going up and buy protection if rates go up. That protection is a cap. So long cap/short call for a zero collar position.

Now that you know you are short the floating rate bond, pretend the cap and floor rate are both 10%.

If rates go to 13%, you recieve 13%-10% = +3% on your cap. But you have to pay 13% on your floating rate bond, so you have a loss equal to -3%. So net-net you are paying 10%.

If rates go to 8%, you recieve nothing on your cap. But you sold a floor, so you have to pay 10% - 12% = -2%. But you get to pay only 8% on your floating rate bond. So gain of +2%. So net-net you are paying 10% on your floating rate bond.

In summary, being short a floating rate bond coupled with a long cap/short put collar means that you are essentially paying a fixed rate.

jarobi04

Thanks bp , I'm convinced now

tikfed

bpdulog Wrote:
-------------------------------------------------------
> janakisri Wrote:
> --------------------------------------------------
> -----
> > ro, Can you give an example ? That would help a
> > lot.
> >
> > Particularly if you show the effect of rates on
> :
> > 1. The collar assuming we're long the collar
> > 2. The floating bond assuming we're long the
> > floating bond.
> >
> > How does all this add up to a fixed rate bond ?
> > That is , not a "band" bond , just one rate.
>
> I am going to use my example from above, except we
> are the issuer of the LIBOR bond this time.
>
> Let's say when you entered into the collar, LIBOR
> was 7% and your cap is at 7%. Assume LIBOR goes up
> to 10%. You pay 10% on your floating rate bond, 3%
> on your cap and floor expires worthless. A month
> later, LIBOR goes up to 15%. So you pay 15% on
> your bond, receive 8% on your cap and the floor
> expires worthless.
>
> At the end of the day, you have capped your
> interest payments to 7%.


Nice explanation. Thanks

WarrenB1

Apologies, i meant you're short the bond (floating rate payer). bpdulog example looks correct: if you are paying LIBOR (currently 7%), long the cap with a strike at 7% and short a floor with a strike of 7% and LIBOR goes to 10%, you pay 10% on the bond, and recieve 3% on the cap, total cost of 7%; if LIBOR goes to 2%, you pay 2% on the bond and pay 5% on the floor, total cost of 7%, hence a fixed-rate position.

kkn006

and if rates fall below the floor ( say 2% ) , what happens ?

Floor is in the money , so you pay Floor-Libor to the collar seller ( you are short a floor )

You also pay LIBOR on the floating rate bond .

So I don't get it .

19831985

janakisri Wrote:
-------------------------------------------------------
> and if rates fall below the floor ( say 2% ) ,
> what happens ?
>
> Floor is in the money , so you pay Floor-Libor to
> the collar seller ( you are short a floor )
>
> You also pay LIBOR on the floating rate bond .
>
> So I don't get it .

I think you would sell the floor at the same rate. Using my example of above, if LIBOR goes to 2%, you pay 2% on the bond, pay 5% on the floor and cap expires worthless.

Total interest cost = 7%

NO EXCUSES

thecfawannabe

You're definitely long the bond. "Purchase cap and sell floor to hedge a floating rate liability." simply means that to hedge exposure where you are paying rates you would enter into a Interest Rate Collar. Essentially, all the Interest Rate Collar is doing is creating a "synthetic" fixed-rate position. The collar creates a band within which the effective interest rate recieved (or paid) flucuates, basically the fluctuation here is zero. Hope that helps!

ap0258

janakisri Wrote:
-------------------------------------------------------
> It does not say if you are long or short the
> bond.
>
> The collar protects against rising interest rates
> ( fueled by the premium on the floor of the
> collar)
>
> The short position on the bond protects against
> falling interest rates . as the NY show pointed
> out earlier a floating rate bond is a position on
> the interest rates , so a short bond is a short
> position on interest rates.
>
> What you're left with , is a constant spread i.e.
> a fixed rate bond


I understand what you're saying, I think. The Secret Sauce basically sums it up as the following:

Purchase cap and sell floor to hedge a floating rate liability.

Purchase a floor and sell a cap to hedge a floating rate asset.

So under the example posted above, we have to assume the floating rate bond is a floating rate liability since he purchased a cap and shorted the floor.

NO EXCUSES

troymo

i agree this is wrong question

it should say that this is from bond issuer perspective