This is not a CFA test question but, after doing some practice exams I came across a question that asked which one of the following was a trait of an inverse floater:
may under certain circumstances, require the bondholder to make payments to the issuer
increase in principal value as market rates decrease and decreases in principal value as market rates increase
has an implicit cap on the maximum coupon rate.
My answer was #1, however, per the discussion the answer was #3. The reasoning is that because the coupon rate on an inverse floater increases when market interest rates decreases, there is an implicit cap on the coupon rate because the market interest rates cannot decline further than zero.
I would argue that #3 is incorrect unless there is a cap/floor stipulated for the security. My rationale was given that there are instances in real life where interest rates fall below 0, Japan 2017, even if theoretically it isn’t possible, it does happen. Anyone else have any thoughts on how to answer this?
The cap is there because the coupon won’t go below 0. The inverse floating part of the inverse floater refers to the coupon. To use your example, in Japan, the yields on some bonds may have fallen below 0 because of how much you have to pay for such a low coupon bond, so you’re effectively paying to put your money somewhere safe, but that’s the yield, not the coupon. There has been talk of negative coupons, but they effectively don’t exist, as the market isn’t really setup to collect coupon payments from bondholders.
As a practical matter, the bond has a cap. It may not be at exactly 0% for the reference rate, but there’s a cap nonetheless. The reference rate isn’t going to reach -1,000%, so there’s a cap.
What’s more interesting about inverse floaters is their effective duration; it can be longer than the bond’s maturity. These are _ very _ twitchy securities.
It’s an inverse floater so I was making the point that the you essentially have a cap on the coupon as the reference can’t go below zero. I’m aware of the difference between a cap and floor.
It wasn’t that your explanation was unclear, nor that I misunderstood it.
What you described was a floor: you said that the coupon could not go _ below _ a given rate.
Especially one week before the exam, we need to be very careful about making mistakes in explanations, because they can confuse the candidates here. All I’m saying is that your explanation was exactly the opposite of what it should have been; for someone who, unlike you, doesn’t have a clear understanding of the difference between a cap and a floor, that can be incredibly confusing.
Much like a few weeks ago when you didn’t know what a credit spread was. If I hadn’t kept pushing the point, that would have been the last word on the subject.
edited by pejp…this statement above was completely incorrect and unfounded. I was thinking of a different user. Apologies.
You’re right, my explanation was slightly confusing. It made sense to me in the context of the question, but in reading again, it is confusing. I should have said reference rate. The OP has my apologies.
If I made a mistake in describing a credit spread, please let me know the thread in which that occurred and I’ll more than happily correct it. I want to be sure that all explanations – mine and everyone else’s – are correct; the candidates here deserve nothing less.
Shit, that wasn’t you. Sorry, I had you confused with someone else. You have my sincere and humble apologies, and I’m going to go back and remove that statement. I’m an idiot.
@S2000 are we to assume that 0% is the effective cap for these types of securities (solely for the test), because otherwise I would still argue that #1 is accurate.