Answer II. is worng for PRM 1?

[Anonymous]

Hi all,

I was doing some practice qquestions when this one came up. I believe that point II. is wrong, as we would need to be long on the FRN and short on the collar right? In addition, in the explanation below, they are writing as if we were short on the FRN (“Now if interest rates rise to say 6%, the borrower pays 6% on the FRN”) In reality, the borrower is the party who buys the FRN, therefore paying a fixed rate, we should pay the same regardless of the floating rate.

Below is the question I am talking about, thanks!:

You are reviewing simulated questions for exam 1

Question 2:
A borrower pays a floating rate on a loan and wishes to convert it to a position where a fixed rate is paid. Which of the following can be used to accomplish this objective?
I. A short position in a fixed rate bond and a long position in an FRN
II. An long position in an interest rate collar and long an FRN
III. A short position in a fixed rate bond and a short position in an FRN
IV. An interest rate swap where the investor pays the fixed rate

(a)
I, II and IV

(b)
I and IV

(c)
II and III

(d)
None of the above

Your Response was incorrect

The correct answer is choice ‘a’

A short position in a fixed rate bond and a long position in an FRN has the effect of paying fixed and receiving floating. The floating received offsets the floating payment on the borrowing, leaving the borrower with just a fixed rate outflow. Therefore the combination identified in statement I can be used to achieve the objective of paying fixed.

A collar is equivalent to a long position in an interest rate cap combined with a short position in an interest rate floor. This has the effect of setting a range within which the investor’s borrowing rate will vary. In the case where the cap and floor rates are the same, the combination of a collar and a long FRN effectively produces an outcome where the holder of such positions pays a fixed rate. Therefore, an interest rate collar can be used to convert the fixed payment to a floating rate payment. [Example: Assume current interest rate is 3%, and therefore the borrower has a liability of 3% on the FRN. Assume that the borrower now buys a collar at the strike rate of 4%. Now the borrower receives 0% (=Max(3 % – 4%, 0)) on the cap part of the collar, and pays 1% on the floor part of the collar (=Max(4% – 3%, 0)). The net borrowing cost therefore is 3% paid on the FRN plus 1% paid on the collar, equal to 4%. Now if interest rates rise to say 6%, the borrower pays 6% on the FRN, and receives 2% from the collar (=Max(6% – 4%, 0) – Max(4% – 6%, 0)), creating a net cost of 6% – 2% = 4%.

A collar is often issued with an FRN to convert floating flows to fixed. Therefore combination II is an acceptable choice.

A short position in a fixed rate bond and a short position in an FRN produces a cash flow that does not produce a net fixed cash outflow when combined with the borrowing. Therefore statement III is not a valid combination.

An interest rate swap where the investor pays fixed and receives floating, when combined with a floating payment on an FRN leaves a net fixed payment, Therefore statement IV is a valid way to achieve the borrower’s objective.

[Anonymous]

Be good for someone to answer this. I don’t really ger it either. Are we allocating 50% of the liability exposure to the FRN and 50% to the collar (or some other mix). That would make sense as both are designed to convert floating to fixed. I can’t think of any reason why you’d use this combination as opposed one or the other…

[Author]

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