CFAI 2011 Mock PM ?'s 2011, present, equation, apologize

torontoanalyst

Hey All,

I am going to apologize in advance if my desription of the proplems sucks but I was looking for some help.

When calculating P/C pariy:

Why does the CFAI not subtract the present value of dividends from the stock price before balancing the Options Parity equation? The formula that I thought accounted for future cash flows is:

C + (X/1+r) = (S-PVD)+P where PVD is the Present value of future dividends.

It seems that the answer the CFAI gives ignores these future cash flows and just balances the equation using the straight stock price creating an inflated call value.



FCFE

I understand that you can solve for FCFE as =EBITDA(1-t)+D(t)-FCi-WCi-I(1-t)+Net borrowed {this is basically FCFF-Interest savings of Tax Shield + Net Borrowed}

Shouldn't this answer also give the same result at FCFE= NI+NCC-FCi-WCi+Net Borrowed? In my equation one is basically just not addig back the Interest Expense to the values given on the I/S thereby not having to calculate FCFF first.

YAhmed

Bump

If anyone knows the answer to the put/call parity I'd like an explanation too. They clearly took the future dividend into account because the answer to A was with the dividend subtracted, but that was the wrong answer.

I'm so tired of mistakes by CFAI, they can't get $hit right, and they expect us to? What a joke.

ppls

For the put call parity question, you don't substract the PV of dividends, you're mixing 2 different concepts - forward valuation and put-call parity relationship.

What the CFA did that boggles me was to take the 6 month risk free rate (0.5%) instead of the 12 months rate (1%) for the calculation.

Swanand

They used the 6 month rate for the risk free rate because you're pricing a 6 month option...You should match the durations similar to using T-Bills for money market based valuations and using T-Bonds in Capital Budgeting...same principle isn't it?

needhelp1700

phrenchy Wrote:
-------------------------------------------------------
> For the put call parity question, you don't
> substract the PV of dividends, you're mixing 2
> different concepts - forward valuation and
> put-call parity relationship.
>
> What the CFA did that boggles me was to take the 6
> month risk free rate (0.5%) instead of the 12
> months rate (1%) for the calculation.


I'm so confused.

pg 178 and 179 of the Derivatives CFA book says specifically "the put-call parity relationshop must be modified to account for cash flows on the underlying asset. "

and put-call parity is call+X/(1+r)=p+[S-PV(CF,0,T)]

zephyranalyst

All right guys, I think I have our answers.

For the Options question:

Schweser SS 17 page 84-85 clearly states that you must subtract the present value of the future cash flow from S to balance the Parity equation. For good measure, this formula is reinforced by Reading 62, page 179 of the CFAI material "we simply reduce the underlying price by the present value of its cash flows over the life of the option". It goes on to state that the equation should look like this:

C + X/(1+r)^t = P + (S - PV (CF,O,T)

In conconclusion, the answer on the CFAI mock is wrong. Phrenchy for your reference, this formula would also apply to Forwards just as easily with an adjustment based on the strike price and value of the forward.


For the FCFE Question:

The CFAI pulled a really nasty trick on us by making us use Jatin's Tax Rate. As a result, we have to start with EBITDA and run through the steps to get to FCFE by using the new tax rate (just going straight from NI will not capture the effect of the new tax rate).





For the record, I hate my life. I am locking myself in a room with no windows to study while my friends go party on a boat. This just happens to be the first day we have seen sun and nice weather in 8 months.

iteracom

Brainwasher, conceptually, you are correct about subtracting dividends in the P/C parity formula, however most of these questions given to us ignore dividends.

In the text for both Level I and II, dividends are ignored, but if they are given in the problem, they must be considered.

I agree that the FCFE question was unfair. I actually thought the tax rate given in the question stem was an intentional distraction designed to fool me into backing out the interest at 1-T.



Edited 1 time(s). Last edit at Monday, May 30, 2011 at 11:54AM by Hank Moody.

comp_sci_kid

Brainwasher - I agree with you that the CFAI answer is wrong - but question 8 is on the errata but all it changes is adding the workd European Option, so they definitely have looked at this question yet aren't changing it.

What happens when they ask this on the exam???

bolligerallstar

Don't know. The lack of effort the CFAI puts into their mock exams is not cool.

xilinx_altera

the mock is just meant to test your level of preparation.... it's not meant to focus all your studies on....just my personal opinion