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)

troymo

i agree this is wrong question

it should say that this is from bond issuer perspective

giants2010

coshair Wrote:
-------------------------------------------------------
> the explanation is correct.
>
> the easiest method is to draw a picture for the
> options payoff (TO DRAW A PAYOFF PUCTURE):
>
> long call
>
> short put
>
> if they have the same exercise price, you can get
> them into one straight line, which is the same
> with a fixed bond payoff.
>
> also, the initial payoff is also 0, for which you
> can use the money from shorting the put option to
> long the call.

That's fine if the question was asking for the effects of the collar; but it's asking for the combined effect of the collar and the floating rate bond.

NO EXCUSES

ap0258

janakisri Wrote:
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> 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

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!

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

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.

jarobi04

Thanks bp , I'm convinced now