- CFA Exams
- CFA Level I Exam
- Study Session 14. Fixed Income (1)
- Reading 44. Introduction to Fixed-Income Valuation
- Subject 6. Yield Measures for Floating-Rate Notes and Money Market Instruments
CFA Practice Question
A five-year variable rate note issued by a BAA-rated issuer resets its coupon rate to six-month LIBOR + .0075. At issuance, the terms of the contract were determined that the issue would be priced at par. Three years after issue, credit conditions have changed and credit spreads have widened (i.e., the credit premiums charged lower credit quality borrowers are greater than during previous market conditions). In this new market environment, ______
A. the price of the variable rate note will be greater than par.
B. the price of the variable rate note will equal par.
C. the price of the variable rate note will be less than par.
Explanation: The margin compensates the note owner for the credit risk associated with the issuer. If this credit risk now requires a greater premium, the fixed margin will reduce the value of the note.
User Contributed Comments 6
| User | Comment |
|---|---|
| shasha | fixed margin of .0075 made lower coupon rate compared to current bond market, so price's down. |
| danlan | As market interest increases, bond price decreases. |
| myanmar | spread widening --> lower prices |
| Adkins | Baa rated fixed income is Medium grade on Moody's Credit spread has widened so high grade bonds will have lower yield requirement (higher demand, higher value), and low grade bonds will have higher yield spreads (lower demand, lower value). IMHO Medium grade bonds would remain the same. |
| octavianus | LIBOR is based on TED spread, with Eurodollars being considered riskier than low risk Treasury bills. LIBOR rate will increase, T-Bill rate will decrease. Higher LIBOR rate + 0.0075 = higher cost of debt =lower variable rate note prices |
| teje | assuming that margin is fixed at .0075, the current market conditions, is pricing in a higher spread possibly through higher margin (LIBOR doesn't have to change). If we assume that the margin on the original issue is fixed, than to compensate for the lack of yield, the price needs to drop. |