- CFA Exams
- CFA Level I Exam
- Study Session 14. Fixed Income (1)
- Reading 42. Fixed-Income Securities: Defining Elements
- Subject 4. Structure of a Bond's Cash Flows

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**CFA Practice Question**

An inverse floater has coupon rate = Maximum [(18% - 2.5r) or 0], where r is the six-month LIBOR rate.

A. The cap coupon rate of 15.5% occurs when r = 1%.

B. The cap coupon rate of 18% occurs when r = 5.5%.

C. The floor coupon rate of 0% occurs when r = 7.2%.

**Explanation:**The coupon rate specification indicates that for all values of 6-month LIBOR greater than 7.2%, the coupon rate = Maximum [18% - 2.5*r or 0] = 0. The cap coupon rate is 18% when r = 0%.

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**User Contributed Comments**
8

User |
Comment |
---|---|

Sudha |
i am confused. i agree with the answer but the formula holds good for "cap rate = 15.5%"? can somebody help? especially as the prefix is maximum. |

nike |
the floor is 0 and the cap is 18% for this inverse-floater. Although B is correct in the formula the "cap coupon rate of 15.5%" is wrong. |

nguyencamtam |
I am confused too, Sudha. I think that maybe we have to find out the theoretical maximum and minimum points of the formula. If it is the case, then the answer is correct, because the minimum or the floor will be 0% when r = 7.2. It is correct only if "the cap will be 18% when r = 0". |

Mak900 |
Usually the inverse floaters are structured to protect the holder by creating a floor value. In this question objective is to multiply 2.5 with a value of r so that 18%-2.5r=0,only 7.2% satisfies this condition. Therefore C is correct |

kellyyang |
who can help me to explain how get the # 7.2%. I am still confused for the question! |

kellyyang |
Never mind! I figured out how to get R=7.2: just used 18%/2.5=7.2 |

viruss |
Cap is 18% when r = 0 and Floor is 0% when r>=7.2%. |

thekobe |
remember a cap is the maximum possible rate and floor is the minimum possible rate. |