Structuring a Floating Rate Note -Financial Engineering 101
June 08, 2006
An FRN is considered structured when an issuer (a company, bank, etc.) is completely swapped out of the coupon that it pays on the note into another funding index of choice.
Let us say that there is an issuer, GoodCorp, which is rated Aa2/AA and wishes to issue a 5-year structured note to fund a project. The funding target of the issuer is LIBOR-0.75%. The issuer approaches a bank, CrookBank (the underwriter of the note) to sell the issue. The bank has a customer, a large institutional money manager, who thinks that the Dollar interest rates will not go any higher and is interested in buying a US Dollar based floating rate note. However, the money manager does not want a LIBOR based FRNs because he thinks the yields are low but instead wants another floating rate index.
The head of Rates Structuring of CrookBank, an exceptionally bright 26 year old Ph.D. named SlickHead thinks the money manager is living on Moon and does the following structuring of the FRN in ten minutes over a Starbucks latte. He is salivating over the fact that he is going to charge upfront 60 basis points as the underwriting fee on this note.
|3 month LIBOR:
|3-year Prime-LIBOR Swap:
|| Prime -3.55% versus LIBOR
|| GoodCorp (Aa2/AA)
|Issuer Funding Target:
The structuring transaction is as follows: the issuer pays a structured note coupon equal to say, to the investor. Now the issuer wants to obtain the funding in LIBOR and therefore what it needs to do is to simultaneously enter into a swap counterparty (mostly likely the same CrookBank or some other bank) to swap out of the Prime index.
Pricing of the Note:
The note is priced at . We need to determine the value of .Let us say that the swap counterparty is willing to pay Prime - 3.55% to the issuer and receive LIBOR flat on a quarterly basis for 5 years (3.55% is the swap spread).
Step 1 : Net Cash Flow Paid by the Issuer
The issuer pays to the investor and LIBOR flat to the swap counterparty whereas receives from the swap counterparty. Therefore,
Step 2: Equating Net Cash Flow to Issuer Funding Cost
The issuer's funding cost (target) is of paramount importance and all cash paid out by the issuer in the form of interest to the investor (as well as swap counterparty) has to be at least equal to his funding cost.
Thus the value of x the spread over Prime has to be equal to 2.80%. But this is not all; there are underwriting fees that the CrookBank will charge on the note.
Step 3: Estimation of Underwriting fees
We need to translate the upfront fee of 60 basis points that the underwriter, CrookBank, will charge the issuer, into annual yield to add back to the spread over prime. For this the fees need to be discounted by the swap rate of 3.55%.
Thus the spread will be 2.90% and the price of the note will be Prime-2.90%.
Reference: An excellent treatment of Structured Note pricing can be found in a rare book called The Structured Note Market by Scott Y. Peng and Ravi E. Dattatreya (Probus Publishing) from where the above example is inspired.
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