My girlfriend is in an interview process for a job at a bank. They
gave her this excercise before making a decision.
I just want to help her answer this question, but I am a marketing
person, I do not know much about this matter, so I thought I give this
medium a try. If you can, please answer a s a p, her assignment due by
end of the day Monday.
Here is the question:
We will be issuing $20 million of preferred stock into a pooled
transaction. The stock pays a quarterly dividend at a rate equal to
3-month LIBOR + 4.00%. Since the stock carries a variable rate
dividend that resets each quarter and we are always fearful that the
index (3-month LIBOR in this case) will rise dramatically, we are
considering a hedge (insurance) where we purchase a cap on our index
in this transaction. The cap contract may be too expensive, so we
would also consider selling a floor contract.
We could purchase insurance that would limit the amount we pay in
dividends. If we bought a 5% cap contract on LIBOR, our maximum
dividend rate would be 9% (5% + 4% spread). The premium on this
"insurance" is approximately $380,000. As a means of possibly
offsetting the price of this, we could sell a floor. In other words,
we would "give up" the opportunity to have LIBOR fall below say 3% if
rates fell, and we would be paid for that. If we bought this 3% floor
and LIBOR were to fall to say 2.50%, our dividend rate would "floor
out" at 7% (3% + 4% spread). We could get approximately $80,000 to
sell a 3.00% floor. We could sell a 2.50% floor for probably $50,000
or so.
3-month LIBOR is currently near 3%. The likelihood that this rate
increases to 5% is 50%. The likelihood that LIBOR goes to 6% is 25%,
and to 7% is 10%. These probabilities are made up, but needed for
this exercise. The questions are....
Should we buy a cap or not?
and what is the potential pitfall to our capital (since we pay the
dividend from capital) if we decide not to buy the cap?
Should we sell the floor to offset the cost of the cap? If so, at
what level (rate)?
Why?? |
