# Sample exam 1

Can someone explain : (1) How loan given out by a company could be viewed as long position in risk free bond and short position in a put. (2) Conversion factor for CTD, even though provided, does it not lead to error if misspecified? the answer seemed to indicate that it is given and hence it is not a source of error. (3) Q25 The bond manager seemed to be taking bets in duration. In the exhibit, it seemed to have data indicating duration different from benchmark by almost 1. although the overall port duration matched the index, I thought that he was taking bets on duration. ans seems to suggest that he is not an active mgr withduration bets. could someone explain. thanks.

(1) When you give out a loan, you will receive interest payments and the principal will be returned at the end of the loan period. This is like holding a bond because when you buy a bond you get periodic coupon payments and a future terminal value. Therefore giving out a loan is like being long a risk free bond. If the loan has no prepayment penalties, you are also giving the right to the borrower to close the loan out any time by paying it in full. In other words you are giving the borrower a put option. Hope it helps.

AnalyseThis Wrote: ------------------------------------------------------- > If the loan has no prepayment penalties, you are > also giving the right to the borrower to close the > loan out any time by paying it in full. In other > words you are giving the borrower a put option. > I thought the short put analogy was completely different than above. As in…by giving out a loan you are long the credit quality of the borrower … or technically short a put option on the credit strength of the borrower to pay off the principal at maturity. This is because the short put option and the lender position has similar payoffs: - If the credit strength deteoriates, your short put position loses money…however the loss is capped at value of the principal. In the loan scenario, you maximum you lose is the principal. So payoff is similar in both situations. - If the credit strength is good enough to pay off the principal at loan maturity, the put option expires out of money. so the short position doesn’t result in a loss. In the loan scenario, you recover the principal. So the loan position doesn’t result in a loss either. Similar payoff. The premium on the put option is similar to the credit spread you recieve on the loan. Correct me if I am wrong.

if you are long bond = long rfr + short put if you are short bond = short rfr - long put

comp_sci_kid Wrote: ------------------------------------------------------- > if you are long bond = long rfr + short put > if you are short bond = short rfr - long put you mean short bond = short rfr + long put ??

I may be wrong too but that’s how I best understood it.

on your ctd question, the ctd will never be misspecified. it is set by the exchange before the contract starts trading and remains fixed (i believe) for the life of the contract. on your bond/put question, it’s just a conceptual framework they throw into the readings somewhere. basic idea is that being long a company’s debt is like being long a risk-free bond plus earning the premium on a put that you effectively write to the shareholders of the company. how are you writing a put to the shareholders? consider what happens if the value of our (very simplified) little company falls below the value of debt outstanding – the shareholders get to walk away by handing over the assets to the bondholders. effectively the shareholders have exercised a put of the assets to the bondholders struck at the amount of company debt. the stockholders, on the other hand are long a call struck at the value of company debt. …or some such nonsense…

fsa-sucker Wrote: ------------------------------------------------------- > comp_sci_kid Wrote: > -------------------------------------------------- > ----- > > if you are long bond = long rfr + short put > > if you are short bond = short rfr - long put > > > you mean short bond = short rfr + long put ?? yeah + long put, sorry

CFAI V5, p. 45-46 explains it rather well long bond = long rfr + short put essentially the put option is the right of stockholders for limited liability (i.e., if the company goes south, shareholders surrender the company’s assets, but are not liable for anything else) bondholders sell that right to shareholders in terms of “short put” and the premium they receiev for that could be thought of a spread earned above Rfr that compensates bondholders for credit risk

thanks everyone for pitching in.

The CTD thing is bizarre. They seem to interchange CTD and futures duration/price all the time in CFA materials. Anyways, i think no matter what they give me, ill assume them to be the CTD duration/price and then divide the dollar duration (product) by the conversion factor