I just got thrown for a loop on this. In the Wiley Mock Exam one of the questions asks you to Value a Capped Floater with a binomial tree. I hadn’t seen this in any of the Schweser notes. and combing through the LOSes for Reading 45 I can’t find a place where they could put this. It IS in the CFAI books but nowhere to be found in the Schweser books.
Is this something you guys are spending time on? I know the default response is to say that if it’s in the CFAI books you need to know it, but which LOS would this fall under? Hopefully I’m not missing something obvious.
Should I know how to do it from the tree? LOS 45.c is the only calculate LOS but it specifies Putable and Callable only. So from my standpoint (even though CFAI probably doesn’t care about that) it wouldn’t encompass a Capped Floater, right? The only LOS in 45 that deals with embedded options in terms of the arbitrage-free framework is 45.c but it just says describe and not calculate.
Although there is an entire section of reading 45 dedicated to floating-rate bonds (section 5), it appears that there are no LOSs that address floating-rate bonds explicitly.
That’s weird.
I’d be prepared for it, nonetheless. Fortuntely, it isn’t difficult.
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In a nutshell, the coupon payment that you get at any node will depend on the rate at the preceding node. If that coupon payment is greater than the cap, you replace it with the cap payment; if the coupon payment is less than the floor, you replace it with the floor payment. Start at the right and work your way left, averaging, discounting, and adding the coupon payment.
The Los doesn’t even have a single word on floater caps and floors. I’ve done all the EOC questions and haven’t seen a single calculation on this. Should we really learn how to calculate this?
Can’t see this either, I don’t think it would be fair to test something that is not described in LOS. Has anyone been able to work through example example 8 question 2 page 359, I don’t get their workings?
Yeah I worked it out a few days ago. Capped floater binomial tree is different to other binomial trees because only the coupons are capped rather than the entire value. The coupons are based on last year’s rate. Coupons are different for different nodes rather than the same.
Got some clarification on this from Schweser. Kent showed me the LOSes from 2015. There was a specific one for this but it was actually removed from the 2016 curriculum. Sounds like it just wasn’t updated in the book maybe. It seems odd but it was deliberately taken out of the LOSes so I’m going to punt this.
So I met this exact same question today. And I’m having difficulties understanding the correct answer.
They ask to value a 3 year FRN that pays Libor + 320bps with a cap at 5.4%.
The question gives a “Binomial Interest Rate Tree Assuming an Volatility of 8%”.
At t = 2, the top node is 2.6865% you see how the coupon will be caped at 5.40 instead of 5.89 and hence the caped floater will be at discount compared to the straight floater.
However, the question seems to assume that the straight floater is priced at par, and the correct answer is less than 100.
How can a bond paying Libor + 320bps be priced at par? or is the tree given not a libor tree, but the tree that makes the bond values at par? is this to be expected?
For example the at t = 2, the bottom node is 1.95%. I priced the bond as (100 + 1.95 + 3.2) / (1.0195) = 103.14. But in the correction, the node shows a value of 100.