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Ticonderoga: Inverse Floating Rate Bond Case Solution

Solution Id Length Case Author Case Publisher
1428 1215 Words (4 Pages) George Chacko, Anders Sjoman Harvard Business School : 205113
This solution includes: A Word File A Word File and An Excel File An Excel File

Greg Bower who is responsible for the capital fund management and monitor the trading risk of the hedge fund’ portfolio. Currently, he is presented with a trade that exposure the company to huge interest rate risk. Therefore, the management is trying to figure out how to hedge and account for this interest risk in a manner that the interest rate exposure is minimum. This trade includes buying inverse floating bond. This kind of security fall under debt category and the coupon rate is a variable which changes as per some benchmark rate. This floating rate note or bond might link to LIBOR or any other interbank market. The coupons are paid in inverse to the benchmark rate. For example, when the LIBOR decreases the coupon rate increase, and the bond holder gets more cash flows. On the other hand, when the LIBOR increases the coupon rate on the bond decrease and the value of the bond fall accordingly. The problem that the company is tackling is that it has been offered a long position on the bond, and the company k knows that the bank has mispriced the bond. So, the objective is to hedge the interest rate risk by accurately.

Following questions are answered in this case study solution

  1. Introduction & Problem Statement

  2. Analysis

  3. Alternative Options

  4. Recommended Action Plan


Case Analysis for Ticonderoga: Inverse Floating Rate Bond

2. Analysis

The current situation asks the company to buy a treasury bond which has a twenty years of maturity, and the bond was issued 18 years ago. The bond’s yield to maturity was equal to the coupon rate at the time of issuance which is 7.29%. This is the reason why the bond was issued at par value. The bank when to acquire the bond divided it up into two pieces one is the floating rate bond which pays the benchmark interest rate and the other is inverse floater which pays coupon as per negative relation to the benchmark rate or LIBOR. To get maximum benefit from the inverse floater, it is essential that the true value of the bond is calculated. In this case, the company is quite sure that the bank has mispriced the bond. So to get the benefit of the trade let see what should be the value of the bond at which the company should exercise the long position.

The value of the bond is simply the present value of all the future cash flows. As the maturity of the bond is 20 years it means that after twenty years’ bond will be natured and the bond holders will get their principle back. This is also established that 18 years have already been passed, and there are only two years left for the maturity of the bond. It means that for the calculation of the value of such a bond only two years of cash flows needed to be discounted. The coupon rate for the bond is 7.29% which is paid semiannually. As a result, this rate is divided by 2 two get the semiannual interest rate, and the coupon payment comes out to be around 36.45. This coupon payment is obtained if we assumed the face value of the bond to be $1000 which is the case.

There are four more periods for which this coupon will be paid, and the present value of these coupons are required. The present value is calculated by using the annuity formula. The discount rate which is used to get the present value is 3% which is the two years Treasury bond yield. The similar discount rate was used to get the present value of the principal which is $1000 in this case. To get the bond price the sum is obtained from both the values.

3. Alternative Options

The company has some alternative available with regards to this trade deal. First of all, the company has the option to purchase the bond by calculating the intrinsic value of the bond. The intrinsic value represents the true and accurate value of the bond which is different from the value that the bank has calculated. Buying the bond at accurate value will allow the bank to earn a profit in short term. But at the same time, banks get exposed to the interest rate exposure which is huge. This is because of the fact that the interest rate is floating which means that the coupons are paid as per the benchmark rate which changes every moment. Thus if the interest rate falls the company will get less coupons.

Although the inherent nature of the bond is such that this risk will be countered by the inverse floating option attached to the bond. This means that when the benchmark rate will be one part of the coupon will decrease, but the other part of the coupon will increase to counter the interest rate risk. By taking this position, the company will not gain or lose anything. Therefore, another alternative is required which could benefit the company monetarily.

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