Floater

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Floater Inverse Floater

• The inverse floater is a derivative security
  synthetically created from the fixed rate debt
  instrument as the underlying collateral.
• The many variations of inverse floaters are known
  as reverse floater, bull floaters, yield curve
  notes, and maximum rate notes.
• The incentive to create synthetic security is to
  create value and reduce risk.
• Example Consider the collateral is a 6.5 percent
  par bond with 25 years to maturity and market
  value Pc of 250 million. From the collateral two
  distinct securities are created a floater (Pf)
  with market value of 200 million and inverse
  floater (Pif) with market value of 50 million as
  defined as follows
• Pc Pf Pif

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• Suppose the coupon of the floater is set as
  follows
• LIBOR 1 ½
  
• The coupon of inverse floater is set to take into
  account the amount of floater relative to an
  inverse floater known as leverage factor L, the
  index (LIBOR) as well as a constant term (q) as
  is defined as follows
• q L (Index)
• The floater coupon is capped and zero floor is
  imposed on inverse floater coupon so that
  weighted average coupon WAC is no greater than
  6.5 the coupon of the collateral.
• WAC .80 LIBOR 1 ½ . 20q 4 (LIBOR)
  

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Example

• Orange County Retirement Fund invested in
  interest rates futures betting the rates are
  expected to go down.
• It also invested heavily in the highly leveraged
  inverse floater.
• The rates continued to go up forcing significant
  margin calls as the interest rate futures
  plummeted due to rising interest rates in 1994
  and the fallout resulted in a loss of 1.7
  billion.
• The fund sued Merry Lynch as an investment
  adviser.
• The inverse floater is structured to help an
  active portfolio manager the opportunity to bet
  in the direction of interest rates, particularly
  those with greater price sensitivity with a
  higher leverage factor.

5
Barbell Bullet

• The portfolio underlying the fixed rate is
  considered a bullet, while the derivative
  portfolio of the floater and the inverse floater
  is known as barbell. The barbell portfolio is
  embedded with option and possesses a positive
  convexity that is highly valuable in the active
  bond portfolio management.
• Suppose the duration of the floater created from
  the collateral is six months and the duration of
  the inverse and the collateral is as follows
• Duration
• Inverse 61.75
• Floater ½
• Collateral 12.35
• Dif (L1) Dc . Pc / Pif

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Active Portfolio Management

• Brandywine Asset Management fund has invested 5
  percent of its portfolio of 1.8 billion in the
  inverse floater with the current yield of 18
  percent.
• The higher yield in the inverse floater is due to
  falling interest rates that make the inverse
  floater such an attractive issue at this time.
• The portfolio manager, betting that interest
  rates are expected to go down, presumably has
  acquired the inverse floater and it appears that
  his bets have paid off.
• However, the earlier example of Orange County
  reveals the other side of the bet where rates
  move in the direction opposite to the bet.

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Creating Synthetic Fixed Rate

• The investor synthetically creates a 6.5 fixed
  rate by buying a floating rate note and
  simultaneously selling a swap that pays floating
  rate and receives a fixed rate as shown in the
  above Exhibit.
• The synthetic fixed rate enables investors to
  adjust the portfolio position by terminating
  (unwinding swap) without the cost of selling and
  repurchasing the entire amount of the principal.

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Prepayment risk

• Prepayment risk exposes the investors into two
  types of risk
• Extension risk
• Contraction risk
• The extension risk arises as the pass-through
  underlying mortgage pays slowly as the interest
  rate rises. When interest rates rise, the
  prepayments decline, as it does not payoff to
  prepay the mortgages. In this scenario, as the
  underlying mortgage debt price falls due to
  rising interest rates, the price of the
  pass-through securities falls even more as
  prepayment slows. The slower prepayment under a
  rising interest rate scenario contributes to
  extension risk that is undesirable to
  pass-through class of securities.
• For example, banks and other financial
  intermediaries that raise capital in the short
  end of the market and invest in long-term debt.
  The assets are long term and their liabilities
  are short term creating a mismatch. The
  pass-through security is long term in nature and
  exposes the financial institutions to extension
  risk.
• Insurance companies find pass-through
  unattractive, exposing them to extension risk in
  the event rates increase and prepayment slows.
• The cash flows from the pass-through securities
  are uncertain, making them undesirable from
  assets liability management for institution such
  as insurance companies.

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Contraction risk

• The contraction risk arises in the event of
  falling interest rates as prepayments speeds up.
• The fall in interest rates makes refinancing
  attractive for mortgagors or individual
  relocating and selling property.
• The pass-through life therefore shortens and
  subjects the investors to contraction risk.
• When the rates fall the price of the plain
  vanilla bonds increases, however, the price of
  the callable pass-through is not expected to go
  up as much.
• The upside potential of the pass-through
  securities is truncated due to negative convexity
  as the prepayment slows, this callable bond is
  expected to be called.
• Pension funds are exposed to contraction risk, as
  the nature of their liabilities is generally long
  term. The pass-through exposes the long-term
  investors to reinvestment rate risk.

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Mortgage and Asset Backed Derivatives

• Pooling single or multi-family mortgages creates
  the pass-through security in a portfolio by
  repackaging their cash flow into new securities
  and selling the new securities to the broader
  classes of investors.
• The objective of repackaging an ordinary coupon
  paying instrument into shares or participation
  certificate through securitization is aimed
• at increasing liquidity,
• marketability,
• as well as realizing economic rent, as investment
  banking firm realizes the difference between what
  it pays for the securities in the pool and what
  it receives from the shares when shares are sold
  in the secondary market.

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PO IO Derivatives

• Stripped mortgage-backed securities issued in
  early 1987 separated coupons from the corpus of
  the underlying pool of mortgages into a class of
  securities known as
• interest-only (IO) securities, with all of the
  principal going to another class known as
• principal-only (PO) securities.

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Example

• Suppose the pass-through underlying the
  collateral is 200 million mortgage securities
  with 6.5 percent coupon and priced at par with
  maturity of 25 years.
• The PO backed by this pass-through is worth 50
  million, since it is a deep-discount bond. The PO
  investors (who receive no coupon interest) will
  receive a dollar return of 150 million (200
  million principal less initial investment of 50
  million) over 25 years, or 5.7 percent annualized
  return.

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Collateralized Mortgage Obligations CMO

• The CMO and stripped mortgage backed securities
  SMBS are derivatives created by redistributing
  cash flow underlying pass-through (the
  collateral) to transfer and mitigate
• The prepayment risk from some classes of bonds to
  other classes based on an established payment
  rules for disbursing the coupon interest
  payments, prepayments and principal repayments to
  different classes.
• The contraction and extension risks, to the
  classes of bonds with risk-return characteristics
  different to that of the underlying mortgages
  that is appealing to the needs and expectations
  of certain segments of investors.

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Sequential Pay Structure

• The principal payment accrues sequentially to the
  first class until it is paid off, while the
  coupon is paid to all of the classes.
• Once the first class is retired the next class
  receives all of the principal and prepayments
  until it is paid off, while other classes only
  receive coupon interest based on their
  outstanding principal in the underlying
  collateral at the beginning of the period.

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Commodity Linked Debt

• Commodity-linked debt or equity instruments
  provide the issuer the opportunity to hedge
  against the volatility of the price of its input
  and reduce and stabilize the volatility of its
  earnings.
• Revenue and profit of the producer of the
  underlying commodity tends to go up or down as
  the commodity price goes up or down worldwide in
  good economic time or periods of recession.

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Gold Linked Note

• Freeport-McMoran Copper and Gold Inc. raised 230
  million in 1993 by issuing gold-denominated
  preferred stocks for 37.8 per share in exchange
  for 1/10 of an once of gold in its funding of the
  expansion of the its gold mining operation.
• To manage its exposure to commodity price changes
  the firm essentially sold forward 600,000 ounces
  of its gold at the current price of 378/ounce
  for delivery at the maturity of the preferred
  stock.
• At the inception of the contract, the issuer
  issued 6 million shares of preferred stock at
  37.80 that amounts to forward sale of 600,000
  ounces of gold for 230 million net of
  underwriting cost.

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Emerging Market Bonds Socks

• The emerging market economies provide fertile
  ground for diversification for investors on both
  sides of the Atlantic. The process of actually
  buying shares in these economies raises few
  problems for investors and portfolio managers.
  For example,
• The bid/ask spreads are usually much higher for
  shares of stocks/bonds in smaller newly
  developing economies.
• The foreign exchange rate risk adds an additional
  element of uncertainty for individuals and
  portfolio managers.
• The host country may also impose capital control
  in order to mitigate the flight of capital that
  hinders the asset allocation decisions.
• Total return swap Can mitigate all of the above
  problems.
• Example Suppose College Retirement Equity Funds
  (CREF) portfolio manager wishes to allocate and
  diversify 5 billion into stocks of emerging
  market economies. CREF may swap total return on
  its growth portfolio with that of the return on
  the Morgan Stanley International Index (MSII) for
  the emerging market over the next two years with
  semiannual settlement. For example, if the
  annualized return on NASDAQ is equal to 11
  percent and the corresponding return on the MSII
  is equal to 14 percent, the CREF portfolio
  manager will receive 75 million from the
  counterparty.

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Catastrophe Bonds

• Property casualty companies issue catastrophe
  bonds by shifting and reallocating business risk
  to large classes of investors.
• The yield on these bonds is slightly higher than
  on comparable bonds, and the bonds are embedded
  with an option that reduces the coupon interest
  or principal payments to investors should
  theissuer suffer large losses due to earthquake
  or hurricane.

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Liability Management

• For most corporations in the United States and
  for multinationals, liability management is
  intended to reduce the cost of borrowing through
  innovative derivatives.
• The objectives of liability management are to
  organize the firms financing activities by
  blending various classes of securities to achieve
  the lowest cost of financing.

21
Exposure Management

• Bank B has 200 million variable rate loan in its
  assets portfolio the rate is to be reset in the
  next three months. The revenue is exposed to
  interest rate risk.
• Bank B wishes to manage its exposure by selling
  3x6 FRA with notional principal of 200 million.
  Exhibit 9.13 presents the cash flow stream that
  is exchanged.

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Swaption

• Swaptions are a right, not an obligation, to
  enter into interest rate swaps sometime in the
  future over a given period.
• For example, a 2x3 swaption at a strike price of
  6.75 percent is a one-year swap starting in two
  years, where the buyer is expecting interest
  rates to go up in two years.
• If the rates go up the buyer of put swaption
  forces the seller to pay floating and receive
  strike price (fixed rate of 6.75 ).
• Call swaptions The buyer of the call swaptions
  however, has the right not an obligation to enter
  into an interest rate swap to pay floating and
  receive fixed where the buyer is expecting the
  rates in the future to fall below the strike
  price forcing the seller to pay the strike price
  and receive the floating rate. The seller is
  obligated to pay fixed and to receive float in
  the event the rates go down.

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Spread on Treasury Yield Curve

• The yield spread on the Treasury bonds and
  Treasury notes is expected to flatten in the next
  three months.
• A portfolio manager buys Treasury bonds March
  2003 futures and simultaneously sells Treasury
  notes futures for delivery in March 2003.
• The ratio spread or the hedge ratio has to be
  estimated as the underlying futures respond
  differently to changes in interest rates, as the
  volatility of the Treasury bonds is greater than
  that of its Treasury notes.
• The portfolio manager buys Treasury bonds March
  2003 futures at 111-19, or 111.59375, and
  simultaneously sells Treasury notes March 2003
  for113-29, or 113.90625 as quoted by the Wall
  Street Journal on October 12.
• To estimate the ratio spread, dollar value of 1
  basis point (DVO1) needs to be calculated for
  both futures and weighted by the respective
  cheapest to deliver (CTD) conversion factors for
  10- and 30-years bonds. The conversion factor for
  the 10- and 30-year CTD bonds, respectively, is
  equal to .8568 and .9353 for March 2003. The DVO1
  is estimated as follows
• DVO1 Treasury bonds
• P 111,430.82 Yield 5.24
• P 111,758.01 Yield 5.22
• P 327.19 327.19 /2
  163.59
• DVO1 Treasury bonds 163.59 / .9353
  174.91
• DVO1 Treasury notes
• P 114,048.88 Yield 4.26
• P 114,224 Yield .26
• P 175.12 175.12/2 87.56
• DVO1 Treasury notes 87.56/.8568 102.19
• Ratio spread or the hedge ratio is estimated as
  follows
• h DVO1 Treasury bonds/ DVO1 Treasury
  notes

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