2016.Fall #13a

The solution says:
Investment income = ∑coupons + (Market Value of AAA – amortized value of AAA)

However, this seems to me to be true only under the following assumptions of the bonds being purchased at Par.

If we assume the bonds are bought at Par then the above formula makes sense since neither a premium or discount on the bond is being amortized. It may have been the intention of the question to assume the bonds are bought at par.

Comments

  • edited February 2019

    That might be part of it (or all of it). If I'm being honest, I cannot answer confidently. I can't find anything in the syllabus reading that provides a definitive answer. When I have time, I'll research this using other sources.

    In the meantime, everyone should make sure to be able to recognize the difference between 2016.Fall Q13a and 2016.Spring Q26b so you know which formulas to use to calculate investment income.

    I have inserted a comment to the CIA.Accouting wiki article about this:
    https://www.battleactsmain.ca/wiki6c/CIA.Accting#2016.Fall_.2313a

  • This is my interpretation of this question (which could be wrong): amortized value or the book value is the original cost of the asset less any amortization, and market value is how much the asset is valued in today's market. By comparing these two, we can get an idea how this asset is doing compared to its original cost, if MV is higher, this probably means we have made a good investment and it's worth more today compared to its original cost (minus depreciation). Then by taking a difference of these two would give us the gain/loss of this asset on paper (unsold), however HFT assets treat these gain/losses as immediate and realized, so it will be counted towards investment income.

  • edited February 2019

    That's a very nice interpretation. I've inserted a link to your comment in the section of the CIA.Accting wiki article that discusses these exam questions. (I've also reorganized that section to be clearer.) See...

  • I think it was just a little bit a simplified situation to make an easy problem. They appear to want you to assume delta(amortization) = 0 (Or more specifically: that the amortized value is also the booked purchase price). For a 10-year bond this is a pretty reasonable assumption (even if not at par). Remember you need to book the asset on a balance sheet for the first time. The assumptions here are actually more important for evaluating the Net Investment Income on AFS/HTM bonds; which is also part of the same problem and these bonds should also earn amortized investment income over time.

    If asset is booked at purchase price
    *delta(amortization) = 0
    *delta(mv) = mv - purchase price = mv - amortized value.
    *HFT = delta(mv)
    *= mv - current amortized value = mv - purchased price

    This is important for the other items listed as well:
    *AFS = delta(amortization) = 0
    *HTM = delta(amortization) = 0
    *OCI.AFS = delta(mv - amortization) = delta(mv) = HFT.

    I'm not sure where in the literature it states that a newly incorporated company cannot earn amortized interest on bonds in the first year of incorporation. If that were the case newly incorporated companies would prefer bonds with coupons (can get investment income immediately) over bonds without (which makes no sense).

    I'm just not sure how this would work with a short-term high yield bonds (30% yield on 6-months). Would it not book a different amortized amount on the balance sheet (rather than then the purchase price) and still records some sort of accrued interest income to offset the difference?

  • Thanks for taking the time contribute to the discussion with such a detailed comment. I've provided a link to your comment in the wiki so everyone can benefit.

  • Hi, I studied this exam a long time ago. Therefore, I have some very old practice exams. There is a question that is exactly the same way and they mentioned the HFT is purchased at par. See exam 7C question 28 2009. As the bonds are purchased on January 1st, I would assume it is at par, otherwise they will have given us the information.

  • @genevieve, I agree with you that the critical assumption here is that the bonds are priced at par, so amortized value = par value = initial price paid for the bond.

    Just adding some details as to why this assumption is required:

    In general, the investment income for year 1 would be the sum of:
    1. The coupon you received during that year, and
    2. The change in value of the bond, i.e. the difference between what you could sell it for at time 1 vs what you paid for it at time 0

    As a single formula, this is: Coupon + (Market value at time 1 - Market value at time 0)

    The CAS formula uses the following formula: Investment income for year 1 = Coupon + (Market value at time 1 - Amortized value at time 1)

    I believe that the only time these formulas would be equal is when the Amortized value at time 1 = Market value at time 0. This should only occur if the bond is priced at par (i.e. there is no premium or discount to amortize).

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