Hey guys, Been away for a while from the forum, but I see that a lot of you are on the right track. Thought I’d add some value here by posting some of the questions that I feel are similar to the ones you will see on the exam. I’ll also be throwing in some challenge questions from time to time… Let’s start off with a couple that are 7/10 on the difficulty scale. Question 1: Fixed Income Which of the following bonds will have the highest YTM everything else constant 1) opion free 2) callable + 1 Year deferral call 3) callable + 2 Year deferral call 4) callable + 3 Year deferral call Question 2: FRA Cost of asset =40,000 Selling Price = 8,000 CFO is less than Net Income by 5,000. How much accumulated depreciation has been charged on the asset?
Q1) 2 Q2) $37000 Definitely challenging! Thanks brother. Btw guys, please do not show your working so that others can try out the questions first.
Good point revenant. Dont show your working guys. I’ll be posting anwers and new questions almost everyday hopefully!
This is great beatthecfa!! Hope you can do this in L2 forum too in May 2010
Q1. 4) Q2. 37,000 Edit: Dont know if my answers are correct but these are quite intelligent questions. Specially the second one.
Q1) 2. Q2) $37,000
1)4 2) 37,000, hollar!!!
- 2 2) 37000
Alrightie then! Time for Solutions! 1. The 2 yr deferral call would have the highest YTM all other things being equal. Compared to an option-free bond, a callable bond (albeit with a call deferral period) must have a higher yield to maturity because its an option that belongs to the issuer. In return for being able to call the bond, the issuer will pay a higher yield on it. Once you have eliminated the first option, the key is to recognize that the issuer will pay the most (in terms of yield) for an option with the lowest call deferral period. Therefore, the answer is option 2. Half of you got this one wrong. I am interested to hear how you thought through this one. 2. CFO will be less than Net Income if there is a gain on the sale of a fixed asset. This gain equals 5,000. The second step is to calculate the book value of the asset. SP - BV = Gain Therefore, BV equals 3000. Since BV equals 3000, the accumulated depreciation is calculated as HC - BV = AD AD equals 37,000 All of you got the second question right. Very crisp thinking folks!
I got 1st one wrong. I chose 3 yr deferral as against 1 yr deferral. My immediate thininking was to compare it to a european call option, with option value as S minus X discounted by number of years. So, I chose 3yrs giving me higher option value vs choosing 1 yr. But, where I got wrong (now that you have given the correct answer!) was that S is the Maturity Value of the Bond, so time scale to discount X starts from Maturity Date and not today. So, a call option deferred closer to Maturity will have a LESSER value than a call option deferred further away from Maturity Date. And I was thinking 2nd question was more intelligent Thanks.
For q2, which LOS has more info on those related calculations. Is that income statement analysis, conversion of indirect to direct?
Its just the indirect method of determining CFO combined with a bit from long-lived assets. Nothing to do with conversion of indirect to direct.
My thinking for Question 1 was as follows If the bond call option is deferred for 1 year ( as against 2 year and 3 year)…the uncertainity about the bond being called is as compared with the bond with 2 and 3 yr deffered call option … So in the near term the Bond 1 has greater probability of beiing called and hence must be compensated for it, so it has the highest YTM Hope Im correct on this! beatthecfa/rus1bus can u pls confirm whether my understanding is correct or not?
You’re on the right track Varun. Keep it up!
Same thinking varun. Investor will require higher yield to compensate them for the uncertainly beyond 1 year compared to 3 years. Great questions so far beatthecfa though I would prefer to see less of these kind in a month’s time
Ok here’s another one, but try to get to the answer without going through the options. In which kind of swap can there be a situation where one counterparty has to make the fixed and the floating payment: A Plain vanilla interest rate swap B Currency swap C Swaption D Equity swap E Basis swap F Synthetic swap G Inverse floater based LIBOR swap