A F/IF security is created with $20,000,000 in principal and a WAC of 7%. 40% of

Question

A F/IF security is created with $20,000,000 in principal and a WAC of 7%. 40% of the principal is allocated to the floater class and the remainder is allocated to the inverse floater class. The floater class will receive LIBOR+50bp

A.What interest rate will be paid to the inverse floater class when LIBOR is at 4%?

B. What is the cash flow to the floater class when LIBOR is at 12%?

C.What is the maximum cap rate payable to the floater class?

D.If instead the principal was allocated 50/50 amongst the floater/inverse floater classes, would the max cap to the floater class increase, decrease, or remain the same?

Explanation / Answer

Principal allocated to Floater Class = 40 % of 20000000 = $ 8000000 and remaining allocated to inverse floater class = 20000000 - 8000000 = $ 1,20,00,000 [ Weights of floater class and inverse floater class = 0.40 and 0.60 respectively]

A) The interest rate that will be paid to the inverse floater class when LIBOR is at 4%.

WAC = Weight of floater class * interest rate + Weight of inverse floater class * interest rate

   7 = 0.40 * (4 + 0.50) + 0.60 * i

   7 = 0.40 * 4.50 + 0.60 i

   0.60i = 5.20

   i = 8.67 % (approx)

Conclusion:- The interest rate that will be paid to the inverse floater class = 8.67 %

B) The cash flow to the floater class when LIBOR is at 12%

= 20,000,000 * 40 % * (12 + 0.50) %

= 8000000 * 12.50 %

   = $ 1000000

Conclusion:- The cash flow to the floater class = $ 1000000.

C) The maximum cap rate payable to floater class will depends on Prevailing LIBOR in the market. The maximum cap rate will be LIBOR + 0.50 Basic Points.

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