LOS b, (Part 3): Describe the structure of floating-rate securities.

Q1. Consider a floating rate issue that has a coupon rate that is reset on January 1 of each year. The coupon rate is defined as one-year London Interbank Offered Rate (LIBOR) + 125 basis points and the coupons are paid semi-annually. If the one-year LIBOR is 6.5% on January 1, which of the following is the semi-annual coupon payment received by the holder of the issue in that year?

A)   3.250%.

B)   3.875%.

C)   7.750%.

Q2. Sometimes floating rate issues have caps and/or floors, which limit the maximum or minimum coupon rate that the issue will pay. Which of the following statements is TRUE with regard to floating rate issues that have caps and floors?

A)   A floor is a disadvantage to both the issuer and the bondholder while a cap is an advantage to both the issuer and the bondholder.

B)   A cap is an advantage to the bondholder while a floor is an advantage to the issuer.

C)   A cap is a disadvantage to the bondholder while a floor is a disadvantage to the issuer.

Q3. Allcans, an aluminum producer, needs to issue some debt to finance expansion plans, but wants to hedge its bond interest payments against fluctuations in aluminum prices. Jerrod Price, the company’s investment banker, suggests a non-interest rate index floater. This type of bond will provide all the following advantages EXCEPT:

A)   the bond agreement allows Allcans to set coupon payments based on business results.

B)   the bond's coupon rate is linked to the price of aluminum.

C)   the payment structure helps protect Allcan's credit rating.

LOS b, (Part 3): Describe the structure of floating-rate securities.fficeffice" />

Q1. Consider a floating rate issue that has a coupon rate that is reset on January 1 of each year. The coupon rate is defined as one-year London Interbank Offered Rate (LIBOR) + 125 basis points and the coupons are paid semi-annually. If the one-year LIBOR is 6.5% on January 1, which of the following is the semi-annual coupon payment received by the holder of the issue in that year?

A)   3.250%.

B)   3.875%.

C)   7.750%.

Correct answer is B)

This value is computed as follows:

Semi-annual coupon = (LIBOR + 125 basis points) / 2 = 3.875%

Q2. Sometimes floating rate issues have caps and/or floors, which limit the maximum or minimum coupon rate that the issue will pay. Which of the following statements is TRUE with regard to floating rate issues that have caps and floors?

A)   A floor is a disadvantage to both the issuer and the bondholder while a cap is an advantage to both the issuer and the bondholder.

B)   A cap is an advantage to the bondholder while a floor is an advantage to the issuer.

C)   A cap is a disadvantage to the bondholder while a floor is a disadvantage to the issuer.

Correct answer is C)

A cap limits the upside potential of the coupon rate paid on the floating rate bond and is therefore a disadvantage to the bondholder. A floor limits the downside potential of the coupon rate and is therefore a disadvantage to the bond issuer.

Q3. Allcans, an aluminum producer, needs to issue some debt to finance expansion plans, but wants to hedge its bond interest payments against fluctuations in aluminum prices. Jerrod Price, the company’s investment banker, suggests a non-interest rate index floater. This type of bond will provide all the following advantages EXCEPT:

A)   the bond agreement allows Allcans to set coupon payments based on business results.

B)   the bond's coupon rate is linked to the price of aluminum.

C)   the payment structure helps protect Allcan's credit rating.

Correct answer is A)

The coupon rate is set in the bond agreement (indenture) and cannot be changed unilaterally. Non-interest rate indexed floaters are indexed to a commodity price such as oil or aluminum. Business results could be impacted by numerous factors other than aluminum prices.
Both of the other choices are true. By linking the coupon payments directly to the price of aluminum (meaning that when aluminum prices increase, the coupon rate increases and vice versa), the non-interest index floater allows Allcans to protect its credit rating during adverse circumstances.

thanks

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