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 million. 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% 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?

Answer 1

The interest share for each class of investors on the day of issue is $80,000. The maximum cap on increases in the base rate of interest for the F investors should be 2%. There is no floor for the IF portion of the offering.

Step-by-step explanation:

To calculate the interest share for each class of investors on the day of issue, we need to first determine the interest payable based on the current balance of $2 million and 8% interest rate. For the Floating Rate (F) investors, their share would be 50% of the interest payable, which is 0.5 * $2 million * 8% = $80,000. The same applies to the Inverse Floater (IF) investors, since their share is also 50%. Therefore, both classes of investors will receive $80,000 as their share of interest on the day of issue.

To calculate the maximum cap on increases in the base rate of interest for the F investors, we need to consider the potential interest rate increase. If we assume a maximum increase of, for example, 2%, the new interest rate for the F investors would be 8% + 2% = 10%. Therefore, the cap on increases should be set at 2%. For the IF portion, which benefits from interest rate decreases, there would be no floor since the interest rate cannot go below 0%.