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In self test of equity in problem 5th

April 18, 2018, 12:16 am
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https://ibb.co/htThz7
https://ibb.co/fgW2z7
https://ibb.co/gW56Rn

As you see, the problem asked to find intrinsic value and said after 3 years the firm’s residual income will decline to its cost of equity with persistence factor , but in the key answer, it use only 2 year which is

intrinsic value =

B​​​​​​0 + [RI​​​​​1/(1+r)] + [RI​​​​​2 /(1+r)2​​​​] + [RI​​​3/((1+r-w)*(1+r)2)]

instead of 

B​​​​​​0 + [RI​​​​1/(1+r)] + [RI​​​​​2 /(1+r)2] + [RI​​​​​3/(1+r)3]+[RI​​​​​4/((1+r-w)*(1+r)3)]

In FCF model the terminal value will be the same as the latter, so I don’t know whether the formula structure of residual model is difference from FCF model or not.

Tks

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Credit Ratings and bond duration

April 18, 2018, 2:49 am
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Does price sensitivity on a bond increase the lower the crediting rating for that specific bond?

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About FCFE with gain from selling old equip

April 18, 2018, 2:49 am
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If I sold equipment for $10 with book value of $2, does this thing affect FCFE?

On Schweser note, it said that have to adjust NCC and FCInv by subtracting $8 gain in both NCC and FCInv (Challenge problem 22nd of LOS31 FCF valuation), so nothing affects to FCFE, but I don’t get a sense of this logic.

I think

FCFE = CFO - FCInv + net borrowing 

In CFO and Net borrowing terms, we can ignore it.

In FCInv, it have to be reduced by $10 due to the cash received from selling equipment, so FCFE is added by $10

I’m not sure for this thing. Pls correct me.

Tks.

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Swap Rate Curve

April 18, 2018, 8:57 am
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Hello Everyone,

I think I am not getting the mechanics of the Swap Rate Curve. So in the Term Structure reading they derive the Swap Rate curve using government spot rates (example 8 pg27). So, since they are effectively discounting cash flows at the risk free rate, does it mean that the swap rate curve which consists of the swap rates, represents risk free rates? And if so, this sound to me like we are effectively solving for the government par rates, since we are solving for the payment (=swap rate) that makes the fixed rate leg to equal 1. Also, if the swap rate curve is a risk free one, what kind of risk does the swap spread reflects? Or we are only calculating the swap spread for risky counter-parties in the swap contract? I am not sure, maybe I am mixing things up, any ideas?

Many thanks

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Too low vs too high

April 18, 2018, 2:28 pm
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Ran into a question that gave this in the problem set:

5% Annual VaR = [9.4% - (1.65 × 14.2%] = -14%

5% Daily VaR = [(0.0376% - (1.65 × 0.0568%)] = -0.056%

The question The calculated percentage value for daily VaR in Exhibit 1 is most likely:

A) correct given the assumptions and method described.
B) too high given the assumptions and method described.
C) too low given the assumptions and method described.

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Comments:

I calculated the daily VAR as [(0.0376% - (1.65 × 0.898%)] = -1.44%, which according the results is correct. However, the use of “too low” and “too high” are kind of weird. I choose B, because exhibit one said the daily VAR was -0.056% which is too high. The correct VAR should be -1.44% (a lower number).

Schweser has the answer as C with the explanation:  This would result in a 5% daily VaR = [(0.0376% - (1.65 × 0.898%)] = -1.44%.

Is my english off? Isn’t the answer too high, not too low? This happen in another question that compared two negative answers as too high and too low, only that time it was the opposite answer as this question.

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Terminal Value with non-annual cash flows

April 18, 2018, 3:12 pm
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How would one derive a terminal value for an asset that is brought to market once every 5-6 years instead of annually as I believe a FCF model would assume annual cash flows to derive a terminal value in a DCF model.

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Credit Default Swap

April 19, 2018, 2:36 am
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On 1 January 20X2, Deem Advisors purchased a $10 million six-year senior unsecured bond issued by UNAB Corporation. Six months later (1 July 20X2), concerned about the portfolio’s credit exposure to UNAB, Doris Morrison, the chief investment officer at Deem Advisors, purchases a $10 million CDS with a standardized coupon rate of 5%. The reference obligation of the CDS is the UNAB bond owned by Deem Advisors.

On 1 January 20X3, Morrison asks Bill Watt, a derivatives analyst, to assess the current credit quality of UNAB bonds and the value of Deem Advisor’s CDS on UNAB debt. Watt gathers the following information on the UNAB’s debt issues currently trading in the market:

  • Bond 1: A two-year senior unsecured bond trading at 40% of par

  • Bond 2: A six-year senior unsecured bond trading at 50% of par

  • Bond 3: A six-year subordinated unsecured bond trading at 20% of par

A is correct. Deem Advisors would prefer a cash settlement. Deem Advisors owns Bond 2 (trading at 50% of par), which is worth more than the cheapest-to-deliver obligation (Bond 1 trading at 40% of par). Deem Advisors can cash settle for $6 million [= (1 – 40%) × $10 million] on its CDS contract and sell Bond 2 it owns for $5 million, for total proceeds of $11 million. If Deem Advisors were to physically settle the contract, only $10 million would be received, the face amount of the bonds and they would deliver Bond 2.

B is incorrect because if Deem Advisors were to physically settle the contract, they would receive only $10 million, which is less than the $11 million that could be obtained from a cash settlement. C is incorrect because Deem Advisors would not be indifferent between settlement protocols as the firm would receive $1 million more with a cash settlement in comparison to a physical settlement.

I do not get the following:

1.Does trading at 50% of par mean that the bond is at default and this is the value the bond holder will recieve at default

2.Why would Deem can cash settle for $6 million [= (1 – 40%) × $10 million] on its CDS, does a $10mm CDS mean that the other party pay the difference between the $10mm and the $4mm?

3.In case of physical settlement, why would Deem deliver the bond, is not he the one that should receive the bond back in order to sell it?

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Protective short example

April 19, 2018, 4:08 am
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This is a question from the credit default swap from the CFA book. I don’t get the answer!

Kand Corporation

Morrison is considering purchasing a 10-year CDS on Kand Corporation debt to hedge its current portfolio position. She instructs Watt to determine if an upfront payment would be required and, if so, the amount of the premium. Watt presents the information for the CDS in Exhibit 1.

Exhibit 1. Summary Data for 10-year CDS on Kand Corporation

Credit spread
700 basis points

Duration
7 years

Coupon rate
5%

 

Morrison purchases the 10-year CDS on Kand Corporation debt. Two months later the credit spread for Kand Corp. has increased by 200 basis points. Morrison asks Watt to close out the firm’s CDS position on Kand Corporation by entering into new offsetting contracts.

Answer:

B is correct. Deem Advisors purchased protection, and therefore is economically short and benefits from an increase in the company’s spread. Since putting on the protection, the credit spread increased by 200 basis points, and Deem Advisors realizes the gain by entering into a new offsetting contract (sells the protection for a higher premium to another party).

Inquiry:

I would understand that the protection buyer would benefit in case he had purchased it earlier than the two months where he has already paid the upfront premium and will benefit from any increase later on. But if the buyer shorts at the time of the increase of the credit spread, he will pay the difference in the credit spread as an upfront premium. 

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CDS

April 19, 2018, 5:24 am
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I have a question regarding the answer!

Another short-term trading opportunity that Smith and Chan discuss involves the merger and acquisition market. SGS believes that Delta Corporation may make an unsolicited bid at a premium to the market price for all of the publicly traded shares of Zega, Inc. Zega’s market capitalization and capital structure are comparable to Delta’s; both firms are highly levered. It is anticipated that Delta will issue new equity along with 5- and 10-year senior unsecured debt to fund the acquisition, which will significantly increase its debt ratio.

A profitable equity-versus-credit trade involving Delta and Zega is to:

  1. short Zega shares and short Delta 10-year CDS.

  2. go long Zega shares and short Delta 5-year CDS.

  3. go long Delta shares and go long Delta 5-year CDS.

B is correct. If Delta Corporation issues significantly more debt, it raises the probability that it may default, thereby increasing the CDS spread. The shares of Zega will be bought at a premium resulting from the unsolicited bid in the market. An equity-versus-credit trade would be to go long (buy) the Zega shares and short (buy protection) the Delta five-year CDS.

If Zega will be bought at a premium, why do not we sell it rather than buy it at a higher price?

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Backwardation and Contango

April 19, 2018, 8:48 am
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I understand what does backwardation and contango mean, but I do not get the market factors that create them. In other words, why would futures prices be lower than spot prices at times and vice versa?

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Practice Problems: I'm scared, what do I do?

April 19, 2018, 4:21 pm
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Hello, I am almost done reading the curriculum and making notes. I should be done by early next week. 

With that said, do I have enough time to do practice problems and mocks in order to have a fighting chance in passing?

I haven’t started any problems so far. I’ve skipped all blue box and EOC. 

I would appreciate some insight into how/if candidates have passed with such limited time left before the exam. 

Also any guidance on how I can achieve this endeavor would be appreciated. Thanks.

Cheers. 

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investment in financial assets - balance sheet

April 19, 2018, 7:25 pm
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Hello,

From what the book says, investments in financial assets will be recorded on the investor’s balance sheets at fair market value (using AFS securities as an example).

Is this correct? Wouldn’t the accounting on the income statement and OCI (for interest, dividends, realized and unrealized G/L) also get recorded in the equity portion of the balance sheet?

Thanks,

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BJ Tolia

April 19, 2018, 7:52 pm
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Any else find him to be a poor teacher for the Kaplan online class?  Can barely understand him and he just flies through the material with no explanation.  Feels like I’m wasting time and money watching it.

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Private Equity Valuation

April 20, 2018, 5:59 am
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There is a sentence in the answer that I do not get;

Chau studies the data and comments: “Of the three funds, the Alpha Fund has the best chance to outperform over the remaining life. First, because the management has earned such a relatively high residual value on capital and will be able to earn a high return on the remaining funds called down. At termination, the RVPI will earn double the ‘0.65’ value when the rest of the funds are called down. Second, its ‘cash on cash’ return as measured by DPI is already as high as that of the Beta Fund. PIC, or paid-in capital, provides information about the proportion of capital called by the GP. The PIC of Alpha is relatively low relative to Beta and Gamma.”

Exhibit 2. Financial Performance of Alpha, Beta, and Gamma Funds

Fund
PIC
DPI
RVPI

Alpha
0.30
0.10
0.65

Beta
0.85
0.10
1.25

Gamma
0.85
1.25
0.75

 

Answer:

A is correct. Chau misinterprets DPI, RVPI, and PIC. The returns earned to date are for each dollar of invested capital, that which has been drawn down, not total returns. Chau mistakenly believes (assuming the same management skill) the result for Alpha Fund at termination will be on the order of 3 × 0.65 = 1.95 instead of 0.65. In both cases, Alpha Fund has underperformed relative to the other two funds.

My question is, why Alpha is deemed to be underperforming!

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Ventures & buyouts

April 20, 2018, 6:07 am
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The exit route for a venture capital investment is least likely to be in the form of a(n):

  1. initial public offering (IPO).

  2. sale to other venture funds targeting the same sector.

  3. buyout by the management of the venture investment.

C is correct. Leverage needed to finance a management buyout is not readily available to firms with limited history.

why can’t there be a buyout by the management, do not they already have experience in the business?

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Capital budgeting -terminal cash flow

April 20, 2018, 9:19 am
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In capital budgeting when determining the terminal cash flow of a project. In case there was a new inventory that was injected in Y=2 to boost sales, why do we add it back in calculating the terminal cash flow?

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Expected Dividend Equation: Schweser vs CFAI

April 20, 2018, 9:19 am
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I’ve come across an instance where CFAI and Schweser have different formulas for the same concept that result in different answers.  I’m guessing the CFAI formula is the one to trust.  This is odd however, and the first time that I’ve seen something like this

Schweser:

Expected dividend = Previous dividend + (Expected increase in EPS × Target payout ratio × Adjustment factor)

CFAI:

Expected dividend = Previous dividend + (Expected earnings × Target payout ratio – Previous dividend) × Adjustment factor

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who said that a putable bond has an uncapped upside potential!

April 20, 2018, 10:31 am
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That question in the cfa book that I do not get it’s answer;

Samuel & Sons is a fixed-income specialty firm that offers advisory services to investment management companies. On 1 October 20X0, Steele Ferguson, a senior analyst at Samuel, is reviewing three fixed-rate bonds issued by a local firm, Pro Star, Inc. The three bonds, whose characteristics are given in Exhibit 1, carry the highest credit rating.

Exhibit 1. Fixed-Rate Bonds Issued by Pro Star, Inc.

Bond
Maturity
Coupon
Type of Bond

Bond #1
1 October 20X3
4.40% annual
Option-free

Bond #2
1 October 20X3
4.40% annual
Callable at par on 1 October 20X1 and on 1 October 20X2

Bond #3
1 October 20X3
4.40% annual
Putable at par on 1 October 20X1 and on 1 October 20X2

 

A fall in interest rates would most likely result in:

  1. a decrease in the effective duration of Bond #3.

  2. Bond #3 having more upside potential than Bond #2.

  3. a change in the effective convexity of Bond #3 from positive to negative.

B is correct. A fall in interest rates results in a rise in bond values. For a callable bond such as Bond #2, the upside potential is capped because the issuer is more likely to call the bond. In contrast, the upside potential for a putable bond such as Bond #3 is uncapped. Thus, a fall in interest rates would result in a putable bond having more upside potential than an otherwise identical callable bond. Note that A is incorrect because the effective duration of a putable bond increases, not decreases, with a fall in interest rates—the bond is less likely to be put and thus behaves more like an option-free bond. C is also incorrect because the effective convexity of a putable bond is always positive. It is the effective convexity of a callable bond that will change from positive to negative if interest rates fall and the call option is near the money.

I do not get the bolded statement, as far as I understand, when u call an option, you have an uncapped upside potential where you gain the difference between the market price-call price - the premium paid. For the putable option I do not get where is the upside potential in case the price increases, should not the option buyer losses??

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Y/K effects during stead state

April 20, 2018, 12:28 pm
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In an end of chapter quiz, it was stated that all 3 are true based on the Y/K equation.  I thought that Y/K was a constant?

1) GDP is growing
2) GDP per capita is growing
3) The GDP to capital ratio (Y/K) is growing

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Effective Duration of a Floating-Rate Bond

April 20, 2018, 1:21 pm
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Hsu then selects the four bonds issued by RW, Inc. given in Exhibit 2. These bonds all have a maturity of three years and the same credit rating. Bonds #4 and #5 are identical to Bond #3, an option-free bond, except that they each include an embedded option.

Exhibit 2. Bonds Issued by RW, Inc.

Bond
Coupon
Special Provision

Bond #3
4.00% annual
 

Bond #4
4.00% annual
Callable at par at the end of years 1 and 2

Bond #5
4.00% annual
Putable at par at the end of years 1 and 2

Bond #6
One-year Libor annually, set in arrears
 

 

A is correct. The effective duration of a floating-rate bond is close to the time to next reset. As the reset for Bond #6 is annual, the effective duration of this bond is lower than or equal to 1.

I do not get why the effective duration of a floating-rate bond s close to the time to next reset!

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