Transcript
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Recent Debt Market
InnovationsPresented
by:Rajneet Kaur
Dilpreet Singh
Harleen KaurSakshi Thakur
M.Com (e.com)
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Introduction
The process of financial innovation involves creating newinstruments and technique by unpackaging and rebinding
the same characteristics in different fashion to suit the
constantly changing needs of the issuers and the
investors . Financial innovation has therefore been a continuous and
integral part of corporate world.
Here we will take a brief look at some of the recent
innovation that have done a lot to alter the financiallandscape.
All of these innovations are the work of financial
engineers but many would not have been possible
without an accommodative regulatory environment.
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Collateralized mortgage obligations
Zero coupon securities
Repurchase agreements
Junk bonds
Economic and legal defeasance
Shelf registration
Floating rate preferred stock and
Reverse floating rate debt
Recent Innovations in debt
market:
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Mortgage-Backed Securities (MBS)
Mortgage-backed securities (MBS) are
securities that represent an interest in a pool
of mortgage loans.
It is like a bond. Instead of
paying investors fixed coupons
and principal, it pays out thecash flows from the pool of
mortgages.
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Scheduled Cash Flows for a 30-Year
Fixed-Rate Mortgage
A 30-year fixed-rate residential mortgage makes a fixed payment each
month until its maturity. Each payment represents a partial repayment of
principal and interest. Over time, as more of the principal is paid off,
interest payments reflect a decreasing portion of each cash flow.
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The scheduled payments on a mortgage are fixed
from one month to the next, the cash flows to the
holder of a mortgage pass-through are not fixed. This
is because mortgage holders havethe option of prepaying their mortgages. When a
mortgage holder exercises that option, the principal
prepayment is passed to investors in the pass-
through. This accelerates the cash-flows to the
investors, who receives the principal payments early
but never receive the future interest payments that
would have been made on that principal. A possible pattern of payments, taking into account
principal pre-payments, of a mortgage pass-through
is illustrated as:
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How It Works/Example:
Let's assume that Ravi wants to buy a house, so he getsa mortgage from XYZ Bank. XYZ Bank transfers money into his
account, and he agree to repay the money according to a set
schedule. XYZ Bank may then choose to hold the mortgage in
its portfolio (i.e., simply collect the interest
and principal payments over the next several years) or sell it.
If XYZ Bank sells the mortgage, it gets cash to make other
loans. So let's assume that XYZ Bank sells Ravis mortgage to
ABC Company, which could be a governmental, quasi-
governmental, or private entity. ABC Company groups Ravismortgage with similar mortgages it has already purchased
(referred to as pooling the mortgages). The mortgages in the
pool have common characteristics (i.e., similar interest rates,
maturities, etc.)
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ABC Company then sells securities that represent aninterest in the pool of mortgages, of which Ravis mortgageis a small part (called securitizing the pool). It sells theseMBS to investors in the open market. With the funds fromthe sale of the MBS, ABC Company can purchase moremortgages and create more MBS.
When Ravi makes his monthly mortgage payment to XYZBank, they keep a fee or spread and send the rest of thepayment to ABC Company. ABC Company in turn takes a feeand passes what's left of Ravis principal and interestpayment along to the investors who hold the MBS.
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All the investors in the same pass-through
instrument hold identical securities with identical
cash flows, identical maturities and identical
rights. This single structure does not suit theneeds of all potential mortgage investors.
Financial engineers set to work on the problem
and eventually created a multiclass mortgage-backed instrument called a collateralized
mortgage obligation
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Collateralized Mortgage Obligation
(CMO)
A collateralized mortgage obligation (CMO) is
a fixed income security that uses mortgage-backed
securities as collateral. Like other structured
securities, CMOs are subdivided into graduated riskclasses, called tranches that vary in degree based
on the maturity structure of the mortgages.
Salomon Brothers and First Boston created the
CMO concept. A CMO is essentially a way to create
many different kinds of bonds from the same
mortgage loan so as to please many different kinds
of investors
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How It Works/Example:
When an investor purchases a CMO, he or she
purchases some class or tranche of the
security whose risk depends on the maturity
structure of the mortgages backing it. These
tranches are usually designated as A, B, C.
In the basic or plain vanilla CMO, each tranche
is entitled to receive a pro-rata share ofinterest, just as with a pass-through, but only
one tranche at a time receives principal.
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Example: At the beginning, only the firsttranche receives principal. This tranche, calledthe fastest pay tranche, receives all principal
collected by the servicer, whether paid ontime or prepaid, until all of the tranchesprincipal has been amortized. The tranche isthen retired and the second tranche becomes
the fastest pay tranche. The number oftranches on any one CMO may be as few asfour as many as ten or more.
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The segregation of cash flows into three sequential pay
tranches is illustrated. All three participate in interestpayments, but principal payments flow exclusively to the A
bonds until they are retired. After that, all principal payments
flow to the B bonds until they are retired. Finally, all principal
payments flow to the C bonds until they are retired.
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The structure of the tranche guarantees thatthe first tranche will have a very short life, thesecond tranche will have somewhat longer
life, that the third tranche will have still longerlife and so on. Thus, a long term instrument-the mortgage or pass-through is used tocreate a series of distinct instruments, thetranches that have short, intermediate andlong lives. The investor can pick the tranchethat most closely mirrors his or her needs.
Because the investor can purchase needspecific securities and, hence, have less riskthan that associated with whole mortgages orpass-through, they are willing to pay little
more for these instruments.
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Asset-Backed Securities (ABS)
An asset-backed security (ABS) is a
security backed by the cash flows of a
pool of assets. Home equity loans, autoloans, credit card receivables, and
student loans commonly back this class
of securities. However, nearly any cash-producing situation can be securitized.
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While any payment stream can be used to
back a debt issue the most frequently used
are automobile receivables.
The structure of ABS is similar to MBS. They
may be single class instruments like mortgage
pass through or multi class instruments like
CMOs.
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Any questions?
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Zero coupon bonds may be long or short term
investments.
Strip bonds:- Investment banks or dealers may
separate coupons from the principal of coupon
bonds, which is known as the residue, so that
different investors may receive the principal andeach of the coupon payments. This creates a supply
of new zero coupon bonds. This method of creating
zero coupon bonds is known as stripping and the
contracts are known as strip bonds. Dealers normally purchase a block of high-quality
and non-callable bondsoften government
issuesto create strip bonds.
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Difference between a zero-coupon bond and a
regular bond
The difference between a zero-coupon bond
and a regular bond is that a zero-coupon bond
does not pay coupons, or interest payments,
to the bondholder while a typical bond doesmake these interest payments.
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Zero Coupon bonds- History
The first zero coupon products involving Treasury securities and
having a maturity greater than one year were introduced in 1982 by
Merrill Lynch known as Treasury Investment Growth Receipts or
TIGRs.
To give competition to TIGRs CATS, LIONs, COUGARs, DOGs andEAGLEs were products of other investment banks similar to TIGRs
which were introduced.
For investment banks, the incentive for creating zero coupon
products was two fold. First, the investment bank purchased a
bond, stripped it to create a series of zeros and then sold these
zeros to public.
The investor benefits afforded by zeros were reflected in their price
so that series of zeros that could be created from a conventional
bond had a collective value that exceeded that of the bond.
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Zero Coupon bonds
The purchaser of zero coupon Treasuries who matches thebonds maturity and horizon is freed from interest rate risk,default risk and reinvestment risk.
Zero coupon bonds are exposed to purchasing power risk-
that expected because of unforeseen changes in the rate ofinflation but these are eliminated by coupon inflation indexedbonds also.
The demand for zeros created a demand for the bonds thatare raw material for making zeros.
Seeing popularity of Zero Coupon bonds, US treasurycreated its own program called Separate Trading ofRegistered Interest and Principal of Securities (STRIPS) thatallows stripping of all non callable coupon issues with originalmaturities of 10 or more years.
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Types of Zero Coupon Bonds
Treasury zerosbacked by the U.S.
government
Municipal bondsissued and backedby municipalities
corporate zerosissued by
corporations
the fourth type iscalled short term
zero coupon bond.
Types
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Advantages
Pension funds and insurance companies like to own long
maturity zero-coupon bonds because of the bonds' high
duration. They are also more advantageous when placed in
retirement accounts where they remain tax-sheltered.
buy zero coupon bonds at a deep discount.
As the bond matures, the interest is accrued and the bond
increases in value.
investors predictability for the long-term.
They allow corporations, municipalities, and the government
to continue using the loan amount without having to pay back
interest.
Diversified portfolio.
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Disadvantages
Interest rates changes can swing price of the
bond in either direction. This means that if
you want to sell it before maturity, profit is not
guaranteed.
Another major drawbacks is that you still have
to pay income taxes capital gains tax.
One final drawback to investing in zeroes is
that they are callable.
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Price of a zero-coupon bond
P = M / (1+r)n
where:
P = price
M = maturity value
r = investor's required annual yield / 2n = number of years until maturity x 2
For example, if you want to purchase a Company XYZ zero-coupon
bond that has a $1,000 face value and matures in three years, and
you would like to earn 10% per year on the investment, using the
formula above you might be willing to pay:
$1,000 / (1+.05)6 = $746.22
When the bond matures, you would get $1,000. You would
receive "interest" via the gradual appreciation of the security.
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The greater the length until a zero-coupon bond's maturity,
the less the investor generally pays for it. So if the $1,000
Company XYZ bond matured in 20 years instead of 3, youmight only pay:
$1,000 / (1+.05)40 = $142.05
This chart shows the growth in value of a $10 000 zero coupon bond
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This chart shows the growth in value of a $10,000 zero-coupon bond,
purchased on January 1, 2011, and maturing on December 31, 2030. The
illustration assumes an original-issue yield of 4.20% and ignores the potential
fluctuation of interest rates during the 20-year period. The purchase price of
such a bond would be $4,323.
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Tax
For tax purposes, holder of a zero-coupon bond owes
income tax on the ir that has accrued each year, even
though the bondholder does not actually receive the
cash until maturity. In India, the tax on income from deep discount
bonds can arise in two ways: interest or capital gains.
It is also law that interest has to be shown on accrual
basis for deep discount bonds issued after February2002. This is as per CBDT circular No 2 of 2002 dated
15 February 2002.
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Zero & Conversion Arbitrage
In conversion arbitrage, an instrument (or group of instruments)with a given set of investment characteristics is converted into aninstrument (or a group of instruments) that has a different set ofcharacteristics.
The creation of zero coupon bonds from conventional bonds is a
classic example of conversion arbitrage.
combine or
decompose
input cash
flowsSecurity n
Security 2
Input securities
Security 1
Security n
Security 2
Output securities
Security 1
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The Zero Coupon Yield Curve
An interesting feature of zeros- which is unique to zeros- is that their
maturity and duration (Macaulay Duration) are identical.
A yield curve drawn on yields of zero coupon bonds against their
maturities is known as zero coupon yield curve or simply spot yield.
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Zeros in Financial Engineering
A zero coupon bond entitles its holder to a single
payment at a pre specified point in time. Both the
initial purchase price and cash flow at maturity are
known at the time of purchase. By stringing together
an appropriate assortment of zeros, a financial
engineer can replicate the cash flow pattern of any
form of debt.
The process by which zeros are created can be reversedand the conventional treasury bonds can be recreated.
Such a strategy would be profitable if conventional
bonds of some maturity are priced above the cost of
creating one via the assembly of zeros.
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Zeros in Financial Engineering
Cash flows
1 timeCash flows
2 time
Cash flows
n time
Cash flows
1 2 3 n
time
Cash flows pattern associated with a
mortgage
A ti ?
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Any questions?
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DEFEASANCE
In the context of an issuers debt obligations,
defeasance involves the acquisition of a
riskless portfolio of bonds such that the cash
flow on the bonds are at
least sufficient to pay
the interest and the
principal on the debt
defeased.
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Types
Economicdefeasance
Legaldefeasance
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Economic defeasance is the process of
removing the debt from a balance sheetby depositing Treasury securities into anirrevocable trust.
An irrevocable trust is a trust thatcannot be altered or terminated by itscreator without the consent of the
beneficiaries. Legal defeasance renders the debt
indenture null and void.
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Example: A corporation sells a 30 year mortgage
bond having a face value of Rs.50 million andpaying a semi annual coupon rate of 6.75%. The
firm uses the proceeds to fund a new plant.
Suppose that ten years later, after interest rates
have risen, the bond is priced to yield 10.25% and
its aggregate value is Rs.35.24 million. The firm is
cash heavy & would like to eliminate its debt.
If the firm buys backs the bond then it will resultin a taxable event- which firm would like to avoid.
The solution is an economic defeasance.
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As it happens, non callable Treasury bonds ofsimilar maturity (20 years) and coincidentally,carrying an identical semi-coupon of 6.75% are
priced to yield 10%. The firm could purchase Rs.50 million (face
value) of these T-bonds at a cost of Rs.36.06million. The T-bonds are then placed in anirrevocable trust with the interest and principalon T-bills used to meet the obligations on thefirms bond issue.
The firms Rs.50 million bond liability is nowdefeased at a cost of Rs.36.06 and the firm can
remove Rs.50 million liability represented bybond from its balance sheet. The gain (Rs.50 million-Rs.36.06 million) is
amortized over the remaining 20 years.
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Defeasance can be employed to remove
liabilities stemming from almost any type ofdebt (except floating rate debt and
convertible debt).The firm has low coupon
debt on its books
Needs to reduce its useof leverage
Anticipates decline in
interest rate
Cash heavy
It
isused
when
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Economic defeasance should not concern the
holders of the firms debt because it does
not trigger a tax event, there are no changes
in the cash flows to the bondholders and the
issuer is still bound by the bond indenture.
Legal defeasance has the additional benefit
from the issuer of removing all restrictive
covenants of the defeased debt.
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Example, under economic defeasance the firmcould not dispose its assets backing its bond.
Such disposition is specifically prohibited by thebond indenture. Once the bond has been legallydefeased, however, the assets can be disposedof in any manner management sees fit.
The downside of legal defeasance is that legaldefeasance results in a taxable event for thedebt defeaser.
For the holders of debt, however, legaldefeasance is attractive because legallydefeased debt receives a top investment graderating.
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The extinguishment of debt. While defeasancetechnically refers to extinguishment by any
method (for example, by payment to thecreditor), in practice it is generally used to meandischarging debt by presenting a portfolio ofsecurities (usually, Treasury obligations) to atrustee who will use the cash flow to service theold debt.
This procedure permits the firm to wipe the debt
off its financial statements and to show extraincome equal to the difference between the olddebt and the smaller, new debt.
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THE REPO/REVERSE MARKET
A repo or more precisely, a repurchaseagreement is the simultaneous sale andrepurchase of security for different settlementdates.
A reverse or, more precisely, a reverserepurchase agreement, is the mirror image of arepo i.e. a reverse repo is the simultaneouspurchase and sale of a security for differentsettlement dates.
Repos and reverse are nothing but short term
loans collateralized by the underlying security. They are used to:1. Obtain short term funding.2. To invest short term cash balance3. To obtain securities for use in short sales.
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Perspective of the Borrower
The borrower sells the securities with thepromise to repurchase them at a later date at aspecific price.
The borrower assumes all interest rate risk
associated with the securities. The difference between the SP and the
Repurchase price represents the interest on theloan.
Thus, a securities dealer holding temporarilyunneeded securities can sell them to an investorunder a repurchase agreement.
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Example: The seller dealer sell $20 mn(FV) 6-month bills to an investor for $19,199,200
with a promise to repurchase the bills 3 dayslater at a price of $19,212,400.
The difference between the SP and the
Repurchase price represents,$13,200,represents interest paid by the selling dealerto the investor for a 3-day loan.
Motivation of the selling dealer is the short-
term loan it receives at a very low interestrate.
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Perspective of the Lender
The lender buys the securities with thepromise to sell them back. The lender mightbe another dealer in need of securities or a
corporate treasurer with excess cash to invest. The lender has a very secure investment.
Firstly, the loan is fully collateralized.
Secondly, the borrower has assumed allinterest rate associated with a change in themarket value of the collateral.
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A large volume of repos are done on anovernight basis called overnight repos. Rates on
overnight repos are usually lower than the callrate. It is better than no return for the investorswho lack access to the call market.
By rolling over overnight repos, the investor can
effectively manage surplus funds when theavailable quantity of surplus funds is uncertainfrom day to day.
Repos for longer term say 30 days are known as
term repo. Reverse market is a very effective way to
acquire securities for short sales.
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JUNK BONDS
Junk Bonds, also known as high yield and speculative gradebonds are bonds having less-than-investment grade rating.
For decades these bonds are difficult, if not impossible to
issue.
They were earlier used as investment grade and subsequentlydeteriorated to speculative grade (with subsequent rise in
yields). Such issues were often termed as fallen angels.
Sellers of junk bonds had difficulty in entering high yield
markets Many money managers managing fixed income portfolios are
barred from investing in any security having a less-than
investment grade rating.
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The inherent default risk of holding junk bonds can bedramatically reduced by diversification. The inability ofissuers to issue such securities limited the ability of
investors to diversify junk portfolios. The nature of the junk bond market began to change in mid
1970s, when the investment banking firm (Drexel)demonstrated, by way of detailed studies, that the yieldsrequired on speculative grade securities were excessive
relative to their actual default risk. This theory purported that long term investors in diversified
junk portfolios would have fared consistently better in year-to-year returns even with some defaults than investors in
investment grade debt. Given this evidence, Drexel concluded that new issues of
highyield securities should be saleable and undertook todevelop this market.
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In the beginning , the
buyers of the high debtwere the individuals andfew high-yield MutualFunds.
But they were later joinedby other holders of fixedincome portfolios includinginsurance companies,
pension funds, banks andsaving and loanassociations.
Any questions?
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Any questions?
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Shelf Registration
In March of 1982, in an effort to reduce the cost and
the time associated with bringing a longer-term issue
to market, the SEC approved rule 415, popularly
known as Shelf Registration. The issuance of securities
has been enhanced by
the introduction of Shelf
Registration.
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Shelf Registration allows a firm to file aregistration statement with the SEC and then totap that filing as windows of opportunity appearor as the need arises. The filing is good for two
years and has reduced flotation costs for thefirms that use it.
Shelf Registration is a registration of a new issuewhich can be prepared up to three years in
advance, so that the issue can be offered quicklyas soon as funds are needed or market conditionsare favorable.
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For example, current market conditions in thehousing market are not favorable for a specific firmto issue a public offering. In this case, it may not be agood time for a firm in the sector (e.g. a home
builder) to come out with its second offering becausemany investors will be pessimistic about companiesworking in that sector.
By using Shelf Registration, the firm can fulfill all
registration-related procedures beforehand and go tomarket quickly when conditions become morefavorable.
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Floating Rate Preferred Stock
Floating Rate Preferred Stock is any
preferred stock on which the dividend rate is
periodically reset or adjusted according to
well defined rule. Some of the variants are Adjustable Rate
Preferred Stock (ARPS) and Single Point
Adjustable Rate Preferred Stock (SPARS)
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ARPS
In ARPS, the rate is periodically reset (usuallyquarterly) to a fixed spread over the highestpoint on the Treasury Yield Curve.
For example, the spread might be 50 basispoints over the yield curve. Thus, if on thereset date, the highest yielding Treasurysecurity is yielding 8.72%, the preferred
stock dividend rate would be set at 9.22%and paid in the stocks par value.
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SPARS
SPARS resets
periodically like ARPS
but the dividend rate is
reset to a specificreference rate such as 3
mth T-bill or 3-mth
LIBOR.
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Reverse Floating Rate Debt
Reverse floating rate debt also called reversefloaters, work the same way as regular floatingrate debt in the sense that the rate is periodicallyreset based on the some reference rate.
But, in this case, the rate adjustment is in theopposite direction of the movement in thereference rate.
This requires that the coupon be stated in terms of
the difference between a constant and thereference rate.
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Conclusion
A great many of the financial engineering
innovations of the last decade and a half
have involved the manipulation oftraditional forms of fixed income
securities and the creation of new forms.
Many of these innovations represents
bold breaks with tradition.
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Some of the more important fixed income
innovation of the last fifteen decade were the
introduction of zero coupon bonds; multi-classmortgage-backed and assets-backed
securities; the development of the
repo/reverse market; the advent of the debtdefeasance; the emergence of a broad-based
junk bond market; simplified procedures for
the issuance of securities; and the creation of
variant forms of preferred stock and reverse
floating rate debt.
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