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CFA Level III
#1

State Bank is about to make a loan at libor +100 basis points

When calculating the futurer value of option premium them use the rateof 7.125+1%, the bank lends at libor + 7.125, however banks should be able to borrow at libor +0, anyway what is the point of this bank existing if it is borrwing at libor +100 and lending at the same rate, and then taking on costs to pay employees…

In fact in the question text they same assume the company can borrow at 7.125, then in the calculations they use libor+1%.

#2

please do not assume on exam day that banks can borrow only at libor w/o any basis on it…

use the banks’ borrowing rate in the specific loan.

#3

actually that is a very valid assumption, libor is inter bank rate, it is exactly the rate at which major banks of good quality lend money to each other as far as i know

http://en.wikipedia.org/wiki/Libor

and the question seems to know that, and they tell you to assume it, then in the answer they forget…

please tell me what is the point of a bank that borrows at libor +100 and lends at libor +100, seems like the shareholders will shell out the costs of running the bank by contributing capital to the bank each year.

i work for a bank, we borrow at euribor

#4

this isnt real life this is an exam do what they say in the book.

end of story

#5

^ cause of people like you this designation is becomming worthless, with all due respect.

The CFA was valuable because unlike other degrees it was supposed to prepare you for the real world, it is very likely CFA will correct this soon, too bad the curriculum is full of mistakes and candidates dont even bother correct them and simply say its just an exam.

#6

I think of it as an opportunity cost. libor+100 would be what the bank _earns if it had not followed a risk mitigation ._It is foregoing that much earning on the premium amount to protect the investment . The premium cost itself is a lost hence opportunity cost

#7

best of luck to you Broke…

#8

Broke, if it is full of mistakes why are you trying to get the charter…?

And remember, the world it isn’t full of major banks who borrow at libor/euribor

I am a gazillionaire and I do not borrow/lend to my friends at libor…I charge them as much as I can!

ERRATA: The CFA Carter IS valuable…

#9

LIBOR is the rate it COULD borrow at now. the problem doesn’t say it DOES borrow this money. If the bank uses its own money to buy the put it does so at the cost of what it could have lent that money out at which is LIBOR + 100 bps. the LIBOR+100 is the opportunity cost to the firm for using this money for something other than lending.

#10

The question clearly sais the bank can borrow at Libor, so no need to think in terms of opportunity cost since there is plenty of more funding available to borrow at LIBOR. If the bank had scarce amount of money to lend that would be relevant, but the bank can borrow at LIBOR as the question states.

Also thinking in terms of opportunity of the money is not very appropriate, the bank can lend to different borrowers at different rates, I lend one of my clients at 9% and another at 3%, and I can find someone who is going down the drain that I can lend at 30% if I wanted to, should I use the 30% as the opportunity cost?

As far as why I am getting the charter, simply a matter of cost analysis, at this point the cost to me is a couple hundred hours I plan on putting for Level III, I just started, money and time for previous levels has already been paid so they are sunk costs.

Had I known all what I know about CFA when I started, it is not worth 900 hours and 3000 USD, however at this point it will cost me no money and only 200 hours of studying, the rest are sunk costs, and that is why i am doing it. No disrespect to any candidates or charterholders, many of whom are much smarter than me and are way ahead of me in life. However the majority just want to get a paper that sais they are charterholders without truely learning, and if you take a sample of those people 2 years after the exam and you compare it to sample of non charterholders with same experience, they are no better.

If I was answering this question at work i would simply solve for the irr

paid 475,000 at time 0, paid 100,000,000 at time 1, got 100,005,556 at time 2, the irr is my return

#11

I found the original book which is written by a Phd, I am sure the guy can better explain why is it he chose to do the assumption some of you talked out, I just have reasons why in practice it is does not mean much, however in his examples he said

"

Assume that the opportunity

cost of lending in the LIBOR market is LIBOR plus a spread of 2.5 percent. Therefore,

the effective cost of the premium compounded to the option’s expiration is22 "

So at least he tells you to assume it, anytime assumptions are needed in a question it should be stated, I can make a million assumptions and solve a question

#12

Money is not free . Every bit of borrowing a bank does is scrutinized , reserves have to be set aside , and regulators look at all borrowing for any purpose as borrowing . There is no free lunch.

That aside , opportunity cost is the way any businessman or banker must look at their borrowing . If borrowing does not generate a net positive spread , it is not worth it. In other words its worth may be less to the lender to the bank than it is to the bank itself

#13

fwiw - it is you who thinks it is an error some 42 days before the exam…

maybe there was time to discuss it if we had all been doing this ages ago. (or maybe even go and ask CFAI and get an answer from them as to why they thought the way they did).

No offense to you, but please spare us these kind of posts and do what you feel like over the next few days…

thanks for sparing us.

#14

This is a ridiculous comment. Seriously, you are questioning whether to use 30% or 3%? Have you ever heard of a weighted average cost of capital? (BTW it’s abreviated WACC - maybe you’ve seen that once or twice?). And this IS absolutely an opportunity cost whether you borrow or use your own funds. If you borrow you can still loan out that borrowed money at LIBOR + r ( which nets to: Pay LIBOR, Receive LIBOR + r = r) you are giving up the extra ® that could have been received if you lent the money out.

Now whose making assumptions…

#15

exactly, WACC, now when did the available investment opportunity become wacc? when a company does the present value of a possible project does it get discounted at a WACC or at the rate available to other ventures? You contradict yourself because what I am suggesting is closer to WACC than what you are suggesting.

Generally a bank would want to focus on earning above its costs of borrowing, if you want to speak in terms of wacc, the equity of the bank is a very small portion compared to total assets, in my bank we have assets of 15 times equity, something called deposits if you ever heard of it once or twice.

So the wacc would be very close to the costs of borrowing represented by libor since the weight of the equity componenet is small, so a bank would be happy earning a spread over libor and not a spread over libor+the spread it usualy demands.

Doing the analysis with the suggested method will lead to bankable deals being rejected, cause the return appears less due to using a higher interest rate, also if you are using the opportunity cost concept, you are assumping you have customers lined up to take loans at that rate, if I had customers willing to take loans now at libor+spread I would be tending to those customers and the guy who wants a loan in 65 days can talk to me in 65 days, i would rather book loans, improve earnings and get get a bonus for doing it.

FinNinja, you have contributed so much to AF, I would appreciate it if we can keep this as an educational discussion, I don’t lose anything if you prove me wrrong without being out to get me. I am here to learn.

#16

Broke - respectfully, I disagree. I don’t work in the banking industry, and frankly I find many of their standards to be a little smoke and mirror(y) for lack of a better word. However, the discount rate for the purchase of the put is stated in the material as an opportunity cost so that’s what I go with. I think it makes sense, but again I don’t work in the banking industry; and if I think something in the banking industry makes sense - it’s probably not how bankers do it.