Floor caps allrightsreserved allrightsreserved

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Unformatted text preview: How do Rate caps work? Floor caps? All Rights Reserved All Rights Reserved Dr David P Echevarria 8 HEDGING EXAMPLE Alternative Time Value Play: Borrowing to finance the buy 1. 2. 3. 3. 4. 5. 5. 6. 6. Suppose we can buy a Zero-coupon bond with 41 quarters remaining Suppose to maturity selling to yield 6%. Price = $ 543,115.59 to Suppose further that we can borrow money at 5 % per annum for 3 Suppose months with the loan collateralized by the Zc-bond. We borrow $ 543,115.59 and repay $ 543,115.59 * 1.0125 = $ We 549,904.53 or a cost of $ 6,788.94 549,904.53 We sell a futures contract to deliver the Zc-bond, 3 months hence, We priced to yield 6.00%: Price = $ 551,262.32 or an income of $ 8,146.73. We have created an arbitrage portfolio in which we have no money We invested and have earned a profit of $ 8,146.73 - $ 6,788.94 = $ 1,357.79 with no risk. In this example, the 6 % is the implied repo rate or the IRR on Zcbond. All Rights Reserved All Rights Reserved Dr David P Echevarria 9...
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