can someone please explain this to me? im completely lost especially with the example on page 74
what exactly are you talking about? in the CFAI texts, Book 5 Reading 57 is about valuing bonds with embedded options. Page 74 is reading 56.
On page 74, they just illustrate that the forward rates can be computed from the spot rates (this relates with the expectations theory). An investor can invest $100 for 2.8%/6months for a year (nominal interest rate of 5.6%) using the one year zero coupon bond. After a year, he would have 100*(1.028)squared= $105.68 Or he could invest it for 6 months at 2.5%/6months, and then enter into a 6x12FRA. What should the FRA rate be? Well, in order to prevent arbitrage, you know that the return has to be the same as it was on th zero coupon bond. therefore, with x being the return on the 6x12 FRA, we get: 100*1.025*x= $105.68 Solver for x and you’ll see that the forward 6 month interest rate 6 months from now has to be 3.1%/6months. --------------------------------------- The definition of Relative Value Analysis is on page 100, first paragraph below “A. The Benchmark Interest Rates and Relative Value Analysis”. It’s fairly conceptual --------------------------------------- Now, my question to you: since virtually all paragraphs in this reading start with “As explained at Level 1 …”, did you identify any material that is true Level 2 material?
Much, if not all of the basics between forward and spot rates was covered in level I. It is presented again as a basis to help explain more complex concepts. If I remember correctly, valuing bonds with embedded options was not covered in as much detail at level I. In order to value a bond with an embedded option, you must understand the difference between the spot rate and forward rate. Using relative value analysis is a LOS, so it is necessary to know it. The spot rate curve is explained at level I; however it is this curve that is used for some relative value analysis. Relative Value analysis is rather straight forward. If the yield on a specific bond issue is higher (lower) than its benchmark interest rate, than it is undervalued (overvalued) and you should buy (sell). My recollection of level I material is a little cloudy (I took level I in december). I do know that OAS is covered in more detail at level II. Valuing bonds with embedded options was not covered in as much detail either (if at all?). You seem to understand the problem on page 74.
sorry this is schweser notes stuff.