Converting Inverse Floater to a regular Bond

Discussion in 'GARP Part 2 (P2) Practice Exam Questions' started by rajeshtr, Dec 25, 2016.

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1. rajeshtrMember

Hi David,
For Answer B) Converting an Inverse Floater(12%-LIBOR) to Fixed Bond(6%).
Should i be evaluating the question as Adding LIBOR and paying 6% (i.e : 12% - LIBOR ++ LIBOR - 6% == 6%).

If there is any other easy way please let me know.

For Answer C) If the Hedge was against dropping Interest Rates --> Would this be the right answer? OR is it like Inverse Floater can never be used as a hedge ever??

Kindly clarify.

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2. David Harper CFA FRMDavid Harper CFA FRM (test)Staff Member

Hi @rajeshtr You can visualize this sort of problem by way of Nefti's cash flow diagrams (see https://www.bionicturtle.com/forum/...ancial-engineering-2nd-ed-by-salih-neftci.18/), however, i myself wouldn't go to that trouble here. Similar to your suggestion, in the evaluation of choice (B) I would start with the simplest representation of what it means to be a "holder of a reverse floater," which is:
1. holder of reverse floater: K(f) - L, where K(f) is the fixed "strike" coupon portion and (L) is the floating LIBOR. For example, a reverse floater might pay (12% - Libor). It's important to be consistent with the sign(+/-). My habit is to use (+) for the cash inflows and (-) for cash outflows, such that +K(f) - L should correctly net to the positive net coupon I expect to receive. Although technically it should be that my net coupon = Max[K(f) - L, 0]. For me, the key part is simply this first step, so that I can test the choice (b) properly
2. Okay then to test (B), I only need to realize how to represent "receive floating/pay fixed in an interest rate swap." That would be +L - K(S) because I receive floating LIBOR (+) and pay the fixed coupon, K(S).
3. Therefore, under choice (B), my portfolio position = reverse floater + long swap = [+K(f) - L ] + [ +L - K(S) ] = +K(f) - K(S) which is a net fixed coupon; i.e., I will be receiving a fixed coupon so this portfolio does synthesize a long fixed-rate bond position
Re answer (C), as Jorion shows in the associated text, a reverse floater tends to have a duration that is multiples greater than the original note. To be long the floater, that is to receive +K(f) - C, is to be highly risk sensitive with a duration that is greater than the underlying maturity (not to be confused with negative duration). Therefore, this is like a leveraged long bond position: it increases (decreases) greatly in value when rates drop (increase). Consequently, choice (c) would be correct if it read instead something like this true statement "A reverse floater hedges against falling benchmark yields." I hope that's helpful!

Last edited: Dec 28, 2016
3. rajeshtrMember

Thanks David for the detailed explanation:

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