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A structured note is a debt instrument with special features designed to appeal to investors, created in conjunction with a derivative position taken by the investor. The special features inherent in the security give investors payoff characteristics on the structured note that are generally unavailable in the market. A typical example of a structured note is an inverse floater, a floating-rate note (FRN) with a yield that varies inversely with movements in interest rates. The issuer of an inverse floater would promise the purchaser of the note a return that varies inversely with interest rates, but the issuer would typically take a position in the swaps market to protect itself from the interest rate risk inherent in such a payoff pattern. With a structured note, the issuer offers an unusual but desirable payoff pattern, but uses derivatives to ensure that its own obligations are of a simple and traditional character.
As we will see with the examples described below, structured notes give investors the opportunities to act on their beliefs about future movements in interest rates, to trade off current yield against future higher yields, to act on specific market views, and to increase or decrease risk to taste.
Structured Notes - The Inverse Floater
An inverse floating-rate note, or inverse floater, has a payoff pattern that is inversely related to a floating reference rate. An inverse floater is also know as a reverse floater, or a bull FRN. (It is called a "bull" FRN because it is attractive to those who are bullish on bond prices, expecting lower interest rates.) For example assume that six-month LIBOR now stands at 7 percent. An inverse floater might promise to pay a floating rate of interest equal to 14 percent minus six-month LIBOR. The initial yield on the inverse floater would be 7 percent. As LIBOR rises, however, the interest paid on the inverse floater would fall. If six-month LIBOR rose to 9 percent, for example, the note would only pay 5 percent, 14 percent minus the six-month LIBOR of 9 percent. IF LIBOR fell from its initial level of 7 percent, the rate paid on the inverse floater would rise. For example, a six-month LIBOR of 5 percent would require a payment on the inverse floater would rise. For example, a six-month LIBOR of 5 percent would require a payment on the inverse floater of 9 percent which equals 14 percent minus the six-month LIBOR of 5 percent.
Consider this same floater if LIBOR rises to a level above 14 percent - say, 17 percent. The terms specified so far would require the purchase of the bond to pay the issuer, because the payment on the bond is supposed to be 14 percent minus LIBOR. Almost all inverse floaters include the stipulation that there will be no interest payment if LIBOR exceeds the stipulated fixed rate, which is 14 percent in our example. This amounts to the inclusion of an option with the inverse floater. It also explains why the fixed rate should be set quite high relative to LIBOR floaters - so that LIBOR will be unlikely to exceed the fixed rate during the life of the bond.
As an example of an inverse floater, consider a firm that issues a $100 million inverse floater that has a maturity of five years, and pays annual interest equal to 14 percent minus one-year LIBOR. The issuer can create this instrument without using the derivatives market, but in the creation of structured notes, it is common for the issuer to use derivatives to maintain a traditional interest rate exposure for itself, while offering a nontraditional payoff pattern to the investor.
Thus, we begin the analysis of this inverse floater by assuming that the firm issues the inverse floater and uses the swaps market to avoid the inverse pattern of interest expenses. Later we show how to create the issuance and purchase of synthetic inverse floater from the same elements.
Assume that the issuer of the inverse floater also initiates a received-fixed swap with terms that match the inverse floater. Specifically, the receive-fixed swap has a tenor of five years and floating-rate payments equal to one-year LIBOR. The notional principal for the swap is $200 million, which is twice as large as the principal on the inverse floater. (We refer to this kind of swap as being "doubled-sized" because the notional principal on the swap is twice as large as the loan principal.) Assuming that the yield curve is flat at 7 percent, the swap fixed rate will also be 7 percent.
Figure 22.7 presents three cash flow time lines pertaining to various features of this inverse floater. The first time line of figure 22.7 shows the cash flow obligations associated with the inverse floater. Each period, the issuer must pay $14 million, less LIBOR x $100 million. It is useful to think of the issuer as paying $14 million and receiving LIBOR x $100 million under the terms of the inverse floater. The second time line shows the cash flows for the "double-sized" received-fixed swap. The inflow is the SFR of 7 percent on $200 million. The third time line shows the combined cash flows from the issuance of the inverse floater and the receive-fixed swap. Except for the cash flows involving the principal on the loan, the annual cash flows are all the same. Therefore, we consider the cash flow at year 3 in detail as representative of the cash flows on the entire financing arrangement.
Figure 22.7 Cash flows for issuing an inverse floater
|Year 3 cash flow on the inverse floater|
|(-14% + LIBOR2) x 100,000,000 =|
|-$14,000,000 + LIBOR2 x $100,000,000||Inverse floater|
|+$14,000,000 - LIBOR2 x $200,000,000||"Double-sized" receive-fixed swap|
|- LIBOR2 x $100,000,000||Result - net cash flow for issuer|
As the preceding analysis shows, for each year the fixed cash flows net to zero. This leaves only floating cash flows. The inverse floater gives the issuer a cash inflow tied to LIBOR that offsets the 14 percent fixed rate. The receive-fixed swap requires a floating cash flow tied to LIBOR on $200 million. The net result is an annual interest payment equal to LIBOR on $100 million. In sum, the issuer has issued an inverse floater, but combined with a receive-fixed interest rate swap, with a notional principal twice as large as the debt issuance principal, the net result is the same as the issuer having issued an FRN with the original desired principal. The final time line of Figure 22.7 reflects the result - it is exactly the same cash flow pattern for issuing straight FRN with a principal of $100 million.
Still viewing matters from the point of view of the issuer, we may view these transactions in two ways. We have just seen that issuing an inverse floater plus initiating a "double-sized" receive-fixed swap is equivalent to issuing a FRN with a principal that is the same as the principal of the inverse floater. For a common notional or principal amount, Figure 22.7 effectively says the following:
Decomposition of inverse floater:
issuing inverse floater + "double-sized" receive-fixed swap = issuing FRN
issuing FRN + "double-sized" receive-fixed swap = inverse floater
or, because being short a receive-fixed swap is the same as being long a pay-fixed swap, the equivalent position is as follows:
Synthesizing issuance of inverse floater:
Equation (22.7) Issuing FRN + "double-sized" receive-fixed swap = inverse floater
This gives a formula for synthesizing the issuance of an inverse floater. We consider the year 3 cash flow for the issuance of the inverse floater synthesized by issuing an FRN and initiating a pay-fixed swap with a larger notional principal:
|Year 3 cash flow on synthetic inverse floater issuance|
|(-LIBOR2) x 100,000,000 =||Issued FRN|
|+$14,000,000 + LIBOR2 x $200,000,000||"Double-sized" pay-fixed swap|
|-$14,000,000 - LIBOR2 x $100,000,000||Result - synthetic inverse floater issuance|
We now consider the inverse floater from the point of view of the investor. If firms or agencies issue inverse floaters, the investor can simply purchase one. Alternatively, the investor can also create an inverse floater for herself. As we have seen, the issuer can synthesize the issuance, so the investor must be able to synthesize the purchase. A synthetic purchase will be just the opposite of a synthetic issuance. If we reverse all of the positions for the synthetic issuances in Equation 22.7 we will have the formula for the synthetic purchases on inverse floater:
Synthesizing Purchase of Inverse Floater:
-issuing FRN - "double-sized" receive-fixed swap = -inverse floater
Equation (22.8) Purchasing FRN + "double-sized" receive-fixed swap = purchasing inverse floater
Equation 22.8 gives the formula for the purchase of a synthetic inverse floater. To see this in detail, we again consider the year 3 cash flow for the purchase of this synthetic inverse floater:
|Year 3 cash flow on synthetic inverse floater purchase|
|+LIBOR2 x 100,000,000 =||Purchase FRN|
|+$14,000,000 - LIBOR2 x $200,000,000||"Double-sized" receive-fixed swap|
|-$14,000,000 - LIBOR2 x $100,000,000||Result - synthetic inverse floater purchase|
As we have seen, any investor with access to the swap market can make her own inverse floater investment by buying an FRN and entering a double-sized receive-fixed plain vanilla interest rate swap. Nonetheless, the market for issuing inverse floaters is fairly large, with billions of dollars of principal being issued each year. This continuing issuance apparently reflects the greater operational efficiency of larger firms and agencies in creating this kind of instrument.
Structured Notes: The Bear Floater
A bear floater is a floating-rate note designed to allow the investor to profit from rising interest rates. Thus, the investor in a bear floater would be bearish on bond prices. Like an inverse floater, the bear floater can be issued as a stand-alone security with peculiar payoff characteristics. Alternatively, the issuer may conceive the bear floater in conjunction with a derivatives position that gives the issuer a more conventional interest rate exposure.
A bear floater is constructed with a high floating rate, less a fixed rate. Assume that the yield curve today is flat at 6 percent. In this environment, a bear floater might have an interest rate equal to:
2 x one-year LIBOR - 6%
With a flat yield curve at 6 percent, the initial yield on this bear floater would be 6 percent. This is the same rate that would prevail on a straight FRN, which would yield 6 percent in this environment.
The special feature of a bear floater comes into play as interest rates rise. A straight FRN will have its yield rise in a 1:1 ratio with market rates. By contrast, the interest rate on the bear floater specified above would have to rise twice as fast as market rates. For example, if one-year LIBOR rises to 9 percent, the yield on the bear floater would rise to 12 percent. If one-year LIBOR fell below 3 percent, the computed rate on the note would be negative. However, a bear floater will typically specify that the interest rate paid on the note cannot be less than zero.
The issuer of the bear floater may simply issue the security and bear the interest rate exposure associated with rising interest rates. More typically, the bear floater will be issued in conjunction with a derivatives position as a structured finance transaction. The first time line of Figure 22.8 shows the cash flows for this bear floater assuming a five-year maturity with annual payments and a principal amount of $50 million. The issuer's annual payment is as follows:
(2 x one-year LIBOR - 6%) x $50,000,000
Figure 22.8 Cash flows for issuing a bear floater to an FRN
If is convenient to think of the issuer's payment as paying 2 x LIBOR and receiving 6 percent each year.
If the issuer combines the bear floater with a plain vanilla interest rate swap, the issuer can choose the ultimate form of its financial obligation. The second time line of Figure 22.8 shows the cash flow for a pay-fixed plain vanilla interest rate swap. The swap has a notional principal of $50 million, a fixed rate of 6 percent, a five-year tenor, and annual payments. Combing this swap with the bear floater gives the issuer an annual interest rate cash flow equal to
[-(2 x one-year LIBOR - 6%) + (one -year LIBOR - 6%)] x $50,000,000
This complicated cash flow simplifies to
-one-year LIBOR x $50,000,000
so the issuer's exposure is simply that of a standard FRN. The third time line of Figure 22.8 shows the resulting cash flows for the issuer from issuing the bear floater and entering a pay-fixed swap as just described. Therefore, we may analyze the issuance of a bear floater as follows:
Decomposition of issuing bear floater:
Equation (22.9) Issuing bear floater + pay-fixed swap = issuing FRN
This analysis also shows how an investor can create a synthetic bear floater, if the issuer wants to have the exposure inherent in issuing a bear floater:
Synthetic issuance of bear floater:
issuing FRN - pay-fixed swap = issuing bear floater
Equation (22.10) Issuing FRN + receive-fixed swap = issuing bear floater
As we have just seen, the issuer of a bear floater can easily arrange for its ultimate exposure to be simply the issuance of a straight FRN. Similarly, the issuer of a bear floater can use swaps to convert the exposure to that of a fixed-rate bond. The first time line in Figure 22.9 shows the cash flows on the bear floater and is identical to the first time line of Figure 22.8. The issuer can use a pay-fixed swap with a notional principal twice that of the bear floater to convert its total exposure to that of a fixed-rate bond. In our example, the issuer would enter a pay-fixed swap with a notional principal of $100 million, a five-year tenor, annual payments based on one-year LIBOR, and a fixed rate of 6 percent. The cash flows for this pay-fixed swap appear in the second time line of Figure 22.9. These are just twice as large as the cash flows for the pay-fixed swap in Figure 22.8. The last time line shows the result of combining the issuance of the bear floater with a "double-sized" pay-fixed swap. The resulting cash flows in the third time line are just the cash flows from the issuance of a fixed-rate bond. Therefore, we have a second potential decomposition of the bear floater issuance.
Figure 22.9 Cash flows for issuing a bear floater to an FRN
Decomposition of issuing bear floater: issuing FRN + "double-sized" pay fixed swap = issuing fixed rate note
This analysis also shows how an investor can create a synthetic bear floater, starting with the issuance of a fixed-rate note:
Synthetic issuance of bear floater: issuing FRN - "double-sized" pay-fixed swap = issuing fixed rate note
issuing FRN + "double-sized" receive-fixed swap = issuing bear floater
What the issuer may synthesize, the investor may also construct. In the same market environment we have been considering, assume that no bear floaters are available and an investor desires the interest rate exposure inherent in the bear floater. Based on our preceding analysis of the bear floater from the point of view of the issuer, we can see how the investor can create a synthetic bear floater. Equation 22.10 showed how the issuer can synthesize a bear floater from an FRN and a receive-fixed swap. The investor can create the same synthetic security, starting with the purchase of an FRN, by taking a position that is the opposite of that shown in Equation 22.10.
Synthetic purchase of bear floater: purchase FRN + pay-fixed swap = purchase bear floater
Equation (22.14) Purchase FRN + "double-sized" pay-fixed swap = purchase if bear floater
As we noted at the outset of our discussion, the bear floater usually provides that the interest rate on the instrument cannot be less than zero. That is, the bear floater normally also includes an interest rate floor to zero. The equivalence in Equations 22.9 - 22.14 do not reflect this extra condition. As discussed, an interest rate floor is an option granted to the purchaser of a debt obligation by the debtor, and has obvious value. In our example of the bear floater, the value of the implicit interest rate floor depends on the likelihood that the specified rate on the floater will reach zero, which equals the probability that LIBOR will fail to 3 percent during the life of the bond.
As we have seen in this discussion, the interest rate exposure of the bear floater issuer does not need to resemble the exposure inherent in the floater itself. By using swaps, the issuer can transform its interest rate exposure. The same principals apply, at least in theory, to the purchaser. The purchaser can obtain the exposure inherent in the purchaser of a bear floater by purchasing ordinary debt instruments and combining them with swaps. However, the continuous large issuances of both inverse and bear floaters bear witness to the great operational efficiency of some market participants in creating these financial structures.
Sources: Damodaran, Hull, Basu, Kolb, Brueggeman, Fisher, Bodie, Merton, White, Case, Pratt, Agee.
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