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
6. Suppose we can buy a Zero-coupon bond with 41 quarters remaining
to maturity selling to yield 6%. Price = $ 543,115.59
Suppose further that we can borrow money at 5 % per annum for 3
months with the loan collateralized by the Zc-bond.
We borrow $ 543,115.59 and repay $ 543,115.59 * 1.0125 = $
549,904.53 or a cost of $ 6,788.94
We sell a futures contract to deliver the Zc-bond, 3 months hence,
priced to yield 6.00%: Price = $ 551,262.32 or an income of $
We have created an arbitrage portfolio in which we have no money
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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- Fall '09
- Interest Rates, Interest rate swap