Question

An issuer is trying to structure a floating rate tranche in a CMO offering. The tranche will be backed by mortgages with an 8 percent interest rate and a current balance of $2,000,000. Interest payable to investors in the floating rate securities (F) and inverse floater securities (IF) will be based on an initial, or base, market rate of 8 percent. Investors in the F portion of the tranche will benefit to the extent of any increases from the base rate of interest and IF investors will benefit to the extent of any decreases from the base rate.

a. Assuming that the F and IF portions of the tranche are equal (50 percent each), what will the share of interest be for each class of investors on the day of issue? A maximum cap must be set on increases in the base rate of interest for the F investors. What would such a cap be? What would be the floor for the IF portion of the offering?

b. Assume that the IF buyers prefer a leveraged offering. If the terms in (a) were altered to a ratio of 60 percent to F investors and 40 percent to IF investors, what would the interest allocation be on the day of issue? What would the cap and floor be?

c. Compare the terms in (a) and (b). Assume now that a 2 percent increase from the base rate of 8 percent occurs immediately after the CMO offering. What happens to the cash distributions to the F and IF investors? Assume that a 2 percent decrease from the base rate occurs. What happens to cash distributions? Which class of investors experiences more volatility in cash flow and, therefore, price volatility? Why?

Answer:

Answer 1

(a)

Scale = 50% / 50% = 1.0

		Scale	Interest Rate	Interest Payable
(F) Floater	$1,000,000	0.50	0.08	$80,000
(IF) Inverse Floater	1,000,000	0.50	0.08	80,000
				$160,000

 

Maximum cap for (F)

(160,000 / 1,000,000) - .08          =        0.080 increase in the interest rate or an interest rate of 16%

 

Maximum floor for (IF)

(.08) x 1                                          =        0.080 decrease in the interest rate or an interest rate of 0%

 

(b)

Scale = 60% / 40% = 1.5

		Scale	Interest Rate	Interest Payable
(F) Floater	$1,200,000	0.60	0.08	$96,000
(IF) Inverse Floater	800,000	0.40	0.08	64,000
				$160,000

 

Maximum cap for (F)

(160,000 / 1,200,000) - .08         =         0.053 increase in the interest rate or an interest rate of 13.33%

 

Maximum floor for (IF)

-(.053) x (1.5)                                =         -0.080 decrease in the interest rate or an interest rate of 0%

 

(c)

Impact of 2% increase in interest rate under 50% proportions

 

		Scale	Interest Rate	Interest Payable
(F) Floater	$1,000,000	0.50	0.10	$100,000
(IF) Inverse Floater	1,000,000	0.50	0.06	60,000
				$160,000

 

F receives $100,000 and IF receives $60,000

 

Impact of 2% increase in interest rate under 60% / 40% proportions

 

		Scale	Interest Rate	Interest Payable
(F) Floater	$1,200,000	0.60	0.10	$120,000
(IF) Inverse Floater	800,000	0.40	0.05	40,000
				$160,000

 

F receives $120,000 and IF receives $40,000

 

Impact of 2% decrease in interest rate under 50% proportions

 

		Scale	Interest Rate	Interest Payable
(F) Floater	$1,000,000	0.50	0.06	$60,000
(IF) Inverse Floater	1,000,000	0.50	0.10	100,000
				$160,000

 

F receives $60,000 and IF receives $100,000

 

Impact of 2% decrease in interest rate under 60% / 40% proportions

 

		Scale	Interest Rate	Interest Payable
(F) Floater	$1,200,000	0.60	0.06	$72,000
(IF) Inverse Floater	800,000	0.40	0.11	88,000
				$160,000

 

F receives $72,000 and IF receives $88,000

Summary

 

		Yield
			2% increase	2% decrease
	Proportions	of Issue	in interest rate	in interest rate
Case     (a)
(F)	50%	8%	10	6
(IF)	50%	8%	6	10
Case     (b)
(F)	60%	8%	10	6
(IF)	40%	8%	5	11

 

 

In case (a) there is an equal impact of changing interest rates on the F and IF yields, that is, each either increases or decreases by 2%. In case (b) however, IF investors will experience greater volatility in yield. This is because the proportion of each class comprising the tranche is now 60 - 40. Therefore, for each 1% change in the underlying interest rate, IF investors will realize a change in yield of 1.5%.