- CFA Exams
- CFA Level I Exam
- Study Session 14. Fixed Income (1)
- Reading 43. Fixed-Income Markets: Issuance, Trading, and Funding
- Subject 1. Classification of Fixed-Income Markets

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**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.

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**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 |