Thank you maratikus.
Ws, We still have a problem. My answer is A while yours is B. which means one of us is making a common mistake that CFAI knows about and voluntarly includes in the answers choices… It s clear that the difference in our answers comes from the slightly different forms of the formula we are using. Actually they are not exactely the same, and it seems it is not irrelevant to point this thing out beacause the choices include both are answers!! I think your formula is a little inaccurate and leads the difference in EAR we got. Please correct me if I am wrong as this is quite important for the exam and the choiuce of the formula to use. Your formula is : 1+(300000/9990865))^(365/180)-1 The one I used is: (10300000/9990865)^(365/180) -1 The first term in your formuala (1) is equivalent to 9990865/9990865. So the formula as you used it implies that the total amount repaid at maturity is 9990865+300000=10,290,865$. Whereas the formula as I used it implies we repaid 10,300,000$, which is actually the real number paid out at the end. You give back the 10M and pay the interest due of 300,000. In your case, it is as if you returned 9990865$ + the interest. This actually explains the diffrence in EAR we got. You had a lowe EAR because your formula assumes you give back 9990865$ while mine assumes you give back 10M$, which is logically the real amount to return… Although the difference is quite small in nominal terms (10M - 9990865= 9135), it is actually the FV of the call option. SO it is as if you neglected the cost of your interest rate call when you computed the EAR. Just beware, because CFAI will certainly provide both answers. I hope I m right or I wrote for 5 minutes for nothing and I m a big blabla that will never show up again on AF 
I tried to incorporate the 9000 into the borrowing cost, but if you just do simple math, you will realize that 9,000 over 10 million is so insignificant that when you do all the button pressing into your calculator you will not even notice any difference. so my answer is still B. who wants to challenge? and why is the answer A?
argghhh! please stop.
whystudy Wrote: ------------------------------------------------------- > I tried to incorporate the 9000 into the borrowing > cost, but if you just do simple math, you will > realize that 9,000 over 10 million is so > insignificant that when you do all the button > pressing into your calculator you will not even > notice any difference. > I’m quite certain that this is not true… $9K for six months is 18 bps of simple interest on $10mm principal.
whystudy Wrote: ------------------------------------------------------- > I tried to incorporate the 9000 into the borrowing > cost, but if you just do simple math, you will > realize that 9,000 over 10 million is so > insignificant that when you do all the button > pressing into your calculator you will not even > notice any difference. > > so my answer is still B. who wants to challenge? > and why is the answer A? The answer is A …because the borrower is compelled to return $10,300,000 at the maturity of the loan at the end of 180 days. In exchange, the borrower had use of $9,990,865 for the term. “Ignoring” the 9K expense for the call option is leading you to the incorrect answer. CALEB correctly points this out in detail in his post. By the way… the frustrating thing about this question and way the CFA requires you to answer it, is the whole shift in interest rate convention, whereby teh CFAI insists on calculating an effective annual rate using daily compounding. That’s most of what the confusion is about. And the annoying thing about it is that I have never, in nearly twenty years of investment experience in short interest rates, heard anyone ever quote or ask for an effective annual rate (versus a simple rate that would be calculated the same way the interest expense is) on short obligations like these. That’s the part that kills me.
CFALEB Wrote: ------------------------------------------------------- > Ws, > > We still have a problem. My answer is A while > yours is B. which means one of us is making a > common mistake that CFAI knows about and > voluntarly includes in the answers choices… > > It s clear that the difference in our answers > comes from the slightly different forms of the > formula we are using. Actually they are not > exactely the same, and it seems it is not > irrelevant to point this thing out beacause the > choices include both are answers!! > > I think your formula is a little inaccurate and > leads the difference in EAR we got. Please correct > me if I am wrong as this is quite important for > the exam and the choiuce of the formula to use. > > Your formula is : 1+(300000/9990865))^(365/180)-1 > The one I used is: (10300000/9990865)^(365/180) > -1 > > The first term in your formuala (1) is equivalent > to 9990865/9990865. So the formula as you used it > implies that the total amount repaid at maturity > is 9990865+300000=10,290,865$. Whereas the formula > as I used it implies we repaid 10,300,000$, which > is actually the real number paid out at the end. > You give back the 10M and pay the interest due of > 300,000. In your case, it is as if you returned > 9990865$ + the interest. > > This actually explains the diffrence in EAR we > got. You had a lowe EAR because your formula > assumes you give back 9990865$ while mine assumes > you give back 10M$, which is logically the real > amount to return… > > Although the difference is quite small in nominal > terms (10M - 9990865= 9135), it is actually the FV > of the call option. SO it is as if you neglected > the cost of your interest rate call when you > computed the EAR. Just beware, because CFAI will > certainly provide both answers. > > I hope I m right or I wrote for 5 minutes for > nothing and I m a big blabla that will never show > up again on AF CFALEB, Are are right…I know where my mistake was. I was wrong. The bottom line is $10300000 is the amount need to pay back (my number was off), and $9990865 was the effective borrowed amount. I was using the interest portion to divide the effecitve borrow amount then add it by one. From now now, I will stick with your way, I think that makes more sense. Thanks. The answer is A.
Bump. This is a great thread to understand this concept. Thanks to ws and CALEB for talking through it.
I thought LIBOR loans all used 30/360 conventions? Is there a reason for using a 365 calendar?
It’s explained above - LIBOR does use a 360 day convention, but computing the EAR uses daily compounding. Two different calculations for two different steps.
An example of Representativeness(Hueristic Bias) of LIBOR vs RFR: LIBOR uses Day count convention. It could be 30/360 or actual/360. 1) 30/360 is most common. 2) Actual/360 is used in caplet/floorlet payoff calculation(payment in arrears) In most example/questions: 1) No compounding for LIBOR rate 2) RFR is usually compounded(continuosly, annually,…).
How is this representativeness bias. For god’s sake - do not make up things not in the curriculum and then post it up here. 1 LIBOR is not a compounded rate - it is an add on rate. So it is not Compounded. 2. RFR is compounded - because it is used for compound interest calculations. That is the reason. Not because of some representativeness bias that you claim.
Sorry CP. I’ll keep the question straightforward. I was not sure if LIBOR should be compounded, but now I know it. Thanks. skillionaire Wrote: ------------------------------------------------------- > It’s explained above - LIBOR does use a 360 day > convention, but computing the EAR uses daily > compounding. > > Two different calculations for two different > steps. Does it use the daily compounding to compute EAR?
it is using a # of days convention to calculate EAR. you have a 180 day rate, now you need to convert to a 365 day rate. so ^(365/180) - 1