Discuss about an adjustable-rate pass-through security

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Reference no: EM131781245

Question: Suppose that a manager buys an adjustable-rate pass-through security backed by Freddie Mac or Fannie Mae, two government-sponsored enterprises. Suppose that the coupon rate is reset monthly based on the following coupon formula:

one-month LIBOR ! 80 basis points

with a cap of 9% (i.e., maximum coupon rate of 9%). Suppose that the manager can use these securities in a repo transaction in which (1) a repo margin of 5% is required, (2) the term of the repo is one month, and (3) the repo rate is one-month LIBOR plus 10 basis points. Also assume that the manager wishes to invest $1 million of his client's funds in these securities. The manager can purchase $20 million in par value of these securities because only $1 million is required. The amount borrowed would be $19 million. Thus, the manager realizes a spread of 70 basis points on the $19 million borrowed because LIBOR plus 80 basis points is earned in interest each month (coupon rate) and LIBOR plus 10 basis points is paid each month (repo rate).

Reference no: EM131781245

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