Suppose that a manager buys an adjustable rate pass through security backed by Freddie Mac or Fannie Mae, two government sponsored enterprises Suppose that the coupon rate is reset monthly based on the following coupon formula 1 month LIBOR 80 basis points with a cap of 9 (i e , maximum coupon rate...

The return earned must be commensurate with the risk undertaken to determine if the strategy is viab ...

Suppose that a manager buys an adjustable-rate pass-through security backed by Freddie Mac or Fannie Mae, two

Question:

Suppose that a manager buys an adjustable-rate pass-through security backed by Freddie Mac or Fannie Mae, two government-sponsored enterprises. Suppose that the rate is reset monthly based on the following formula:
1-month LIBOR + 80 basis points
with a cap of 9% (i.e., maximum rate of 9%).
Suppose that the manager can use these securities in a repo transaction in which (1) a repo margin of 5% is required, (2) the term of the repo is one month, and (3) the repo rate is 1-month LIBOR plus 10 basis points. Also assume that the manager wishes to invest $1 million of his client’s funds in these securities. The manager can purchase $20 million in of these securities because only $1 million is required. The amount borrowed would be $19 million. Thus the manager realizes a spread of 70 basis points on the $19 million borrowed because LIBOR plus 80 basis points is earned in interest each month rate) and LIBOR plus 10 basis points is paid each month (repo rate).
What are the risks associated with this strategy?
Coupon
A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity. Coupons are usually referred to in terms of the coupon rate (the sum of coupons paid in a... Par Value
Par value is the face value of a bond. Par value is important for a bond or fixed-income instrument because it determines its maturity value as well as the dollar value of coupon payments. The market price of a bond may be above or below par,...