It seems they have said that the answer is 17B and the reasoning is
"B is correct. The difference between historical cost and par value must be amortized under the effective interest rate method. If the par value is less than the initial cost (stated interest rate is greater than effective rate), the interest income would be lower than the interest received because of amortization of the premium.
If I bought a premium bond, should’nt I be getting more since I paid the premium? Why isn’t the answer 17C?
‘Amortized under effective interest method’. I don’t understand this statement either. I know its going to be amortized and reach par value over time but the effective interest method part…?
Yes I did pass the CFA Level 1 exam but my memory is failing me and I cannot recall fixed income knowledge. Your help is much appreciated !
If you buy a bond at a premium, the YTM is less than the coupon rate. You are getting more: you’re getting a higher coupon than the YTM you should be getting. Therefore, when you amortize the premium (which is a built-in loss), it lowers your interest income so that, ultimately, it is the YTM.
That means that your interest income is computed using the book value of the bond times the YTM at purchase. This number will differ from the coupon you receive; the difference is the amortization of the premium. It will lower the book value, and next year you will have a lower book value, lower interest income, and lower amortization amount.
For example, suppose that you bought a 10-year, 6% coupon, annual pay (to make it easier), $1,000 par bond for $1,100. The YTM is 4.7224%. So the first year you show interest income of:
$1,100 × 4.7224% = $51.95.
You receive a coupon payment of $60, so the difference – $8.05 – reduces the book value to $1,091.95. The second year, you show interest income of:
$1,091.95 × 4.7224% = $51.57.
You still receive a coupon payment of $60, so the difference – $8.43 this time – reduces the book value to $1,083.52.
So the coupon I receive will be the same just that the interest portion of it will decrease over time to align with par value.
I don’t know why my image links to the CFA textbook questions got removed. I am new to this website, is there some protocol I need to follow before posting image links? Because I can’t really type the whole thing.
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