Question

82. A dealer believes that the bonds issued by Super-Tee Enterprises (SUTEE) are considerably overvalued and wants to benefit from the mispricing. For achieving this objective, the dealer borrows 100 par value bonds of SUTEE from an institutional investor and lends cash in return. The bonds have a stated coupon rate of 7.5%. The above transaction will best be known as a:

A. repurchase agreement, and the coupon will belong to the seller of the security.

B. reverse repurchase agreement, and the coupon will belong to the borrower of the security.

C. reverse repurchase agreement, and the coupon will belong to the borrower of cash.

83. Tony Sam has invested in a floating rate bond based on Libor. Due to changing market conditions, Sam is particularly concerned with his investment value deviating from par value. Sam’s concern is most likely:

A. justified.

B. exaggerated, since floating rate securities have little market risk.

C. exaggerated, since floating rate securities have little interest rate risk.

Answer 1

Answer 82) Option C) reverse repurchase agreement, and the coupon will belong to the borrower of cash.

Dealer believes that bond is overpriced and will fall in value.

In a repurchase agreement, the dealer would sell the security to a counterparty with an agreement to buy back at a higher price at a later date. [Seller's point of View]

In a reverse repurchase agreement , the dealer will buy the securities with an intention of returning them back in the future at a profit. [Buyer's Point of view]

Option A) is incorrect because he is borrowing the security and hence it will be a reverse repurchase agreement.

Option B) is incorrect because the coupon will belong to the borrower of cash and not to the borrower of security.

Answer 83) Option A) Justified. Floating rate bonds have high interest rate risk. This is because if the interest rates rise then value of the bond will decrease.

Option B) is incorrect since floating rate securities have alot more than little market risk. They are sensitive to interest rate changes, changes in market conditions such as weaking of economy, etc.

Option C) is incorrect since floating rate bonds have high interest rate risk.