Question

ANSWER GIVEN, PLEASE PROVIDE EXPLANATION STEP BY STEP
ANSWER = Rate of the collateral: 6.75% & Cap=12.5%
PLEASE SHOW WORKING OUT

3. Assume that the formula for the coupon rates of a floater and an inverse floater are: Floater coupon rate: reference rate + 1.5%
Inverse floater coupon rate: 12% - reference rate Answer the
following questions:
(A) What is the coupon rate of the fixed rate collateral for these two floating rate
bonds?
(B) Suppose the floor for the inverse floater is 1%. What would be the cap of the
floater?

Answer 1

A) Coupon Rate of Floater note increases with increase in Reference Rate, whereas Coupon Rate of Inverse Floater Note decreases with increase in Reference Rate.

And Reference Rate is a fixed Rate

And Floater Coupon rate + Inverse Floater Coupon Rate = 2 * Reference Rate

As, Floater Coupon Rate = Reference Rate + 1.5% and

Inverse Floater Coupon Rate = 12% - Reference Rate

Let, F = Floater Coupon rate

I = Inverse Floater Coupon rate

R = Reference Rate

Hence, F = R+1.5% & I = 12%-R

F + I = (R+1.5%)+(12%-R)

2R = 13.5%

Hence, Reference Rate = Coupon Rate of the fixed rate collateral = 6.75%

B) Given that,

Floor of Inverse Floater is 1%

Hence, 12% - Reference Rate > 1%

Reference Rate < 11%

1.5% + Referenced Rate < 11% + 1.5%

Floater Coupon Rate < 12.5%

Therefore, Cap of Floater Coupon Rate is 12.5%.