- CFA Exams
- CFA Level I Exam
- Topic 6. Fixed Income
- Learning Module 3. Fixed-Income Issuance and Trading
- Subject 1. Fixed-Income Segments, Issuers, and Investors
CFA Practice Question
The six-month LIBOR rate is 6.667%. An investor has the opportunity to select one of two securities. Both securities have identical timing of promised payments and identical credit and liquidity risks. The first security is a five-year, semi-annual-pay, floating-rate note with coupon payments determined by the prevailing six-month LIBOR rate. The second security is a five-year, semi-annual-pay inverse-floater with coupon rate = Maximum [(1.25 x (12% - r)) or 0], where r is the six-month LIBOR rate.
II. At the coupon reset date, if r = 6.667%, the floating rate security will produce greater cash flow.
III. If the investor expects dollar-denominated short-term interest rates to rise, the floating-rate note promises greater cash flows.
IV. The maximum rate payable on the inverse floater (i.e., the "cap") is 12%.
I. The inverse floater will provide greater cash flows at all future values of the six-month LIBOR.
II. At the coupon reset date, if r = 6.667%, the floating rate security will produce greater cash flow.
III. If the investor expects dollar-denominated short-term interest rates to rise, the floating-rate note promises greater cash flows.
IV. The maximum rate payable on the inverse floater (i.e., the "cap") is 12%.
Correct Answer: II and III
If the six-month LIBOR rate rises, the coupon rate on the inverse-floater will decline.
User Contributed Comments 16
| User | Comment |
|---|---|
| vincenthuang | Why is II correct? |
| jingyz | I think II is correct. 6.667%>6.6662%(CPN rate of inverse floater) |
| Chet | The only issue I take with the question, and the fact that II in particular is marked as being correct, is that we are only told that the floating-rate note (coupon=LIBOR+quoted margin) references LIBOR, without knowing the quoted margin. Under a scenario of rising interest rates, it is a "reasonable assumption" to answer that a floating-rate note promises greater cash flows, but, we cannot determine the coupon for the floater. |
| stefdunk | it doesn't matter what the quoted margin is. Assuming the quoted margin to be 0 or greater, the answer holds true |
| haarlemmer | Well, I thought that difference in II is ignorable. |
| mtcfa | To me, if r = 6.667, then both bonds are equal. Thus only III is true. (1.25 x (.12 - .06667) = 6.666% I would have marked them down as equal on the test, thinking that 1/10th of 1 basis point was irrelevant to the computation. I guess bot. |
| cwrolfe | There is no quoted margin on the floater...the coupons are determined by the "prevailing" LIBOR. Also, try telling an investor that 6.667% is the same as 6.66625% on a 5-year note. |
| Lucho | floating rate note will generate gretare cash flows under this assumptions. Inverse floater will do the same in case of declining interest rates scenary |
| thekapila | Technically only III is correct .II is giving the same cash flow at 6.667 interest rate |
| steved333 | II is correct. The answer states that the cash flow would be higher, not how much higher it would be. And 6.6667% is indeed higher than 6.6625% |
| jonrat | III is right, II is only just right. How about one answer to each question. That is fair! |
| hyperinflation | "The six-month LIBOR rate is 6.667%" My oh my have the times changed! |
| cleopatraliao | thats tricky if i use BAII PLUS calculator mine only display 4 digits...and they all gave me the same answer i.e. 0.0667...how do i suppose to tell they r different? |
| pandianki | You can change the amount of decimals that your BAII Plus displays. To display 6 decimals: [2nd][.], 6[ENTER] |
| johntan1979 | II is correct due to the 0.00075% difference. No matter how small, that is an arbitrage opportunity there. They would be equal if instead of 6.667%, it is quoted as 20/3% |
| jonan203 | mtfcfa: $1,000,000 x 1 bp = $100 $1,000,000,000 x 1 bp = $10,000 1 bp = a lot of money, relatively speaking |