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Basic Question 1 of 6

The six-month LIBOR rate is 6.667%. An investor has the opportunity to select one of two securities. Both securities have identical timing of promised payments and identical credit and liquidity risks. The first security is a five-year, semi-annual-pay, floating-rate note with coupon payments determined by the prevailing six-month LIBOR rate. The second security is a five-year, semi-annual-pay inverse-floater with coupon rate = Maximum [(1.25 x (12% - r)) or 0], where r is the six-month LIBOR rate.

I. The inverse floater will provide greater cash flows at all future values of the six-month LIBOR.
II. At the coupon reset date, if r = 6.667%, the floating rate security will produce greater cash flow.
III. If the investor expects dollar-denominated short-term interest rates to rise, the floating-rate note promises greater cash flows.
IV. The maximum rate payable on the inverse floater (i.e., the "cap") is 12%.
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User Contributed Comments 16

User Comment
vincenthuang Why is II correct?
jingyz I think II is correct. 6.667%>6.6662%(CPN rate of inverse floater)
Chet The only issue I take with the question, and the fact that II in particular is marked as being correct, is that we are only told that the floating-rate note (coupon=LIBOR+quoted margin) references LIBOR, without knowing the quoted margin. Under a scenario of rising interest rates, it is a "reasonable assumption" to answer that a floating-rate note promises greater cash flows, but, we cannot determine the coupon for the floater.
stefdunk it doesn't matter what the quoted margin is. Assuming the quoted margin to be 0 or greater, the answer holds true
haarlemmer Well, I thought that difference in II is ignorable.
mtcfa To me, if r = 6.667, then both bonds are equal. Thus only III is true. (1.25 x (.12 - .06667) = 6.666% I would have marked them down as equal on the test, thinking that 1/10th of 1 basis point was irrelevant to the computation. I guess bot.
cwrolfe There is no quoted margin on the floater...the coupons are determined by the "prevailing" LIBOR.

Also, try telling an investor that 6.667% is the same as 6.66625% on a 5-year note.
Lucho floating rate note will generate gretare cash flows under this assumptions. Inverse floater will do the same in case of declining interest rates scenary
thekapila Technically only III is correct .II is giving the same cash flow at 6.667 interest rate
steved333 II is correct. The answer states that the cash flow would be higher, not how much higher it would be. And 6.6667% is indeed higher than 6.6625%
jonrat III is right, II is only just right. How about one answer to each question. That is fair!
hyperinflation "The six-month LIBOR rate is 6.667%"

My oh my have the times changed!
cleopatraliao thats tricky if i use BAII PLUS calculator mine only display 4 digits...and they all gave me the same answer i.e. 0.0667...how do i suppose to tell they r different?
pandianki You can change the amount of decimals that your BAII Plus displays.

To display 6 decimals:
[2nd][.], 6[ENTER]
johntan1979 II is correct due to the 0.00075% difference. No matter how small, that is an arbitrage opportunity there.

They would be equal if instead of 6.667%, it is quoted as 20/3%
jonan203 mtfcfa:

$1,000,000 x 1 bp = $100
$1,000,000,000 x 1 bp = $10,000

1 bp = a lot of money, relatively speaking
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CFA® 2025 Level I Curriculum, Volume 4, Module 3.