CFAI mock exam 2016 - question no 50 - please help

can someone help me with question 50 of the cfai mock exam 2016 - morning session … what i don’t get is how we get to -1.86% yield over 2 years.


Can you copy paste the question here?

You can access it here.

That is one tough question. I checked my notes I actually guessed it (and got it right)… Looking at the answer explanation I haven’t got the slightest clue what the question is asking.

I must admit I was afraid to paste it because of copyright. …but I don’t get the return mentioned in the answer sheet … what was your score on that mock??

Yes it is a tough question indeed. From what i understand the investor buys the bond at 101.15 and after 2 years sees that the rates are not as expected by the forward rate per the spot rates the (2,1) forward rate was 7.03% but in reality at t2 the spot rates are flat at 8% so market is discounting by a higher rate because of which price goes down(that is why overvalued).At t2 you can calculate the price of the bond n=3 y=8 pmt=7 fv=100 and pv=97.42 so he sells at 97.42 bought at 101.15 loss of 3.73 ie -3.6876% in 2 years.

You aren’t the first one to look for the answer… I get a total return over the two-years horizon of 4.93% (after the curve shifts up) with IRR of CF0 = -101.5 , CF1 = 7, and CF2 = (97.42+7) ==> IRR 4.93% I wonder if it’s not a mistake

Yeah you are right but what about reinvesting the coupons at the forward rates?shouldnt it be 7(1.0501)(1.0703)+7(1.0703)?

I did the usual hpy calculation ie( 97.42 +7+7-101.5 )/101.5 = 0.097 -> 1.097^1/2 -1 = 4.77%

Yes true, we should take reinvestment into account! (I don’t agree with your calculations though, we only need to reinvest the cash flow from Y1 over the second year)

Let’s assume that the rate over year 2 materialize as anticipated, i.e. actual rate over year 2 = 5.01%

We get a total return of: [(7*1.0501 + 7 + 97.42) / (101.50)] ^0.5 -1 = 4.94% (very small difference since we first assumed that the coupon of Y1 was reinvested at the IRR of 4.93% instead than 5.01% )

I still believe this is a mistake in the correction…

You should try it that way: Total (compounded) return = [(97.42+7+7) / 101.50] ^1/2 -1

But yet, since you can reinvest your coupon > Total (compounded) return = [(97.42+7+7 + reinvestments) / 101.50] ^1/2 -1

I found that mock sooo hard …