Scot Bank has been given the opportunity to buy a large number of US dollar-denominated bonds issued by Scottish Energy Enterprises (SEE), a triple-B rated British utility company.
This would amount to a principal amount of $100 million—but the bonds are currently trading in the market at a discount.
The bonds carry a fixed annual-pay coupon of 6 per cent and have exactly five years to maturity—so the first coupon you will receive from buying the bonds is one year away. There is no accrued interest.
The bonds are being offered to Scot Bank at 84.837 per cent of par. At this price, the yield to-maturity on the bonds is 10 per cent. Unfortunately, Scot Bank, although interested in the opportunity, would want to hold a floating rate asset, not a fixed-coupon bond.
However, the Lightning Investment Bank (LIB) has offered to repackage the bonds for Scot Bank as synthetic floating rate notes via a special purpose vehicle (SPV).
The deal is as follows: Scot Bank will provide $100 for each bond purchased and will redeveloper, as the floating rate, plus a 20 basis points spread (0.20 per cent) over the reference rate for the five years, plus a repayment of the $100 principal at maturity. These floating rate payments will take place at the end of each year (i.e. annually) to match the payments on the bond and up to and including the final maturity at the end of year 5.
The terms and conditions in the US dollar interest-rate swaps market are given below:
Par Swaps Curve
Maturity 1 Year 2 years 3 Years 4 Years 5 Years
Par swaps rate
9.50% 9.59% 9.62% 9.69% 9.70%
LIBOR: London Interbank Offered Rate (the reference rate for the floating side of the swap)
Swap interest rates are annual pay
Questions for Part A
1. Briefly explain why Scot Bank would wish to hold a floating rate asset issued by SEE rather than the fixed rate bonds.
2. Analyze the synthetic floating rate note offer for value. Explain and show how the cashflows of the transaction add or do not add up. In doing this, you might like to briefly
comment on the following issues/questions:
a. Is the transaction a reasonable one from Scot Bank’s perspective or is the Lightning Investment Bank using its superior knowledge of financial engineering and derivatives to exploit the bank?
b. Consider in your thinking that Scot Bank is not a sophisticated user of derivatives.
c. Is any mispricing (i.e. deviation from fair value) significant and what are the advantages/disadvantages of Scot Bank entering into the synthetic being offered by Lighting Investment Bank?
d. Explain and show how LIB has structured the deal. (Remember: follow the cash!)