CFA Practice Question

There are 490 practice questions for this study session.

CFA Practice Question

A bond has an arbitrage-free value of $95.36 and is trading at a price of $94.60. Would the dealer strip this issue and what would be the gain or loss?

A. Yes; the gain would be 6.1%
B. No; the loss would be $0.76
C. Yes; the gain would be $0.76
Correct Answer: C

User Contributed Comments 16

User Comment
chenyx If the arbitrage-free value is greater,the dealer shoukd strip the issue.
MaiHuong How to compute 0.76?
(95.36-94.6)/94.6 = 0.8
o123 95.36-94.6=0.76
the question didnt ask for the percentage gain/loss.
capitalpirate what about if arbitrage-value less, wouldnt he still strip it? u make money irrespective, as long as it different, right???
Bududeen if the arbitrage value is less loss no striping occurs
mattg Bududeen & chenyx: you are incorrect - if the arbitrage free value is LESS than the price, you SHOULD strip and sell the pieces because you can buy them relatively cheaply and sell them at a premium, thereby making a risk free profit. That is why the answer is C above
thekid mattg: YOU ARE INcorrect!

if arbitrage free value is LESS than price, then you would RECONSTITUTE the strips (meaning you would rather put the strips together and sell as a whole which will give you a higher price).
zkhan87 and sell the bond at the spot to take advantage of the arb opp
zkhan87 if arb free value is less than spot, sell the bond at spot and buy the zero strips
gulfa99 i think the answer is B. As per the question the fair value of the bond is 95.36 but is trading lower at 94.60...if i strip the bond, meaning sell the bond and buy the strips i would lose money! can someone explain why i am wrong
gulfa99 from another angle, i would buy the bond, and sell the strips for higher cash-flows to earn a profit..in this case c makes sense
2014 Price should be equal to free arbitrage value then only there is no opportunity to buy or short am i rite
so both sides sell strips & buy strips is it depending upon opportunity
johntan1979 I believe the answer should be B.

In previous examples, current values are all higher (100) than arbitrage-free values. The whole idea of stripping is if arbitrage exists, and it exists only if the arbitrage-free value is lower than the current value. In that way, you make a risk-free profit by selling at spot.

Answer should be B. Very sure about this.
johntan1979 #@#$ sorry. Forget my previous comment. In the notes, the arbitrage-free price is higher ($930.67). Sell and gain $30.67 risk-free profit over current value ($900).

So for this question, answer C is correct. It's very confusing but once you understand the concept, you know there's only one answer.
Shaan23 You guys are making this complicated. It's just like in equities when we did the intrinsic value and market value questions.

The IV(Arbitrage Value) > Market Price(price trading at) ---> so it is undervalued so BUY it ---> there is a gain.
khalifa92 arbitrage value is like intrinsic value
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