Question

Discuss the problems that are likely to be faced by the company if the proposed bond was issued based on the terms of proposal Issue the proposed corporate bond with a variable annual coupon rate based on the Bank Base rate so that the annual coupons will be Bank Base Rate + 40 basis points

Answer 1

As the coupon rate is variable, so the bank doesn't have a fixed liability. The liability is dependent on the bank's base rate. If the bank's base rate rises then coupon payment will increase, so that year's liability will increase. Asset liability management will be bit difficullt to carry as the liability is not fixed in this case. Bank usually try to match the asset's exposure with laibility's exposure. If he needs to pay 10% interest on bonds issued, then it will give loan of similar percentage to offset the liability exposure. Here in this case, the loan rate will be difficult to judge as the liability will change everytime.

To off-set this floating rate exposure, bank may enter into receive floating SWAP, but as it will be a forward agreement. So default risk is there.

answered by: anonymous