Question #52

of 111 A cap on a floating rate note, from the bondholder's perspective, is equivalent to: A) owning a series of calls on fixed income securities. B) writing a series of puts on fixed income securities. C) writing a series of interest rate puts. Jacob Bower is a bond strategist who would like to begin using fixed-income derivatives in his strategies. Bower has a firm understanding of the properties fixed-income securities. However, his understanding of interest rate derivatives is not nearly as strong. He decides to train himself on the valuation and sensitivity of interest rate derivatives using various interest rate scenarios. He considers the forward London Interbank Offered Rate (LIBOR) interest rate environment shown in Table 1. Using a rounded daycount (i.e., 0.25 years for each quarter) he has also computed the corresponding implied spot rates resulting from these LIBOR forward rates. These are included in Table 1. Table 1: 90-Day LIBOR Forward Rates and Implied Spot Rates Period (in months) LIBOR Forward Rates Implied Spot Rates 0 × 3 5.500% 5.5000% 3 × 6 5.750% 5.6250% 6 × 9 6.000% 5.7499% 9 × 12 6.250% 5.8749% 12 × 15 7.000% 6.0997% 15 × 18 7.000% 6.2496% Bower has also estimated the LIBOR forward rate volatilities to be 20%. The particular fixed instruments that Bower would like to examine are shown in Table 2. He also wants to analyze the strategy shown in Table 3. Table 2: Interest Rate Instruments Dollar Amount of Floating Rate Bond $42,000,000 Floating Rate Bond paying LIBOR + 0.25% Time to Maturity (years) 8 Cap Strike Rate 7.00% Floor Strike Rate 6.00% Interest Payments quarterly Table 3: Initial Position in 90-day LIBOR Eurodollar Contracts Contract Month (from now) Strategy A (contracts) Strategy B (contracts) 3 months 300 100 6 months 0 100 9 months 0 100