CFA CFA Level 1 FRA questions

FRA questions

  • This topic has 6 replies, 3 voices, and was last updated Jun-17 by edulima.
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    • edulima
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      Thought I’d start this thread for FRA questions… with a specific question on Reading 34 (on quality of cash flow statements)

      On section 6 the author discusses “Tax benefits from stock options”. On the first paragraph of that section it is stated that “at the time the stock option is exercised, however, the company is permitted to take a deduction on its tax return for that year reflecting the difference between the strike price and the market price of the option.”

      My problem is with that last word (“option”); logic tells me that it should be “stock” instead, as in “reflecting the difference between the strike price and the market price of the stock.”

      Does anyone have similar feelings as me?

    • Pranav
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      @edulima, stocks don’t have strike prices, do they? i think only options have that…
      market price is current price and strike price is the price at which the option will be exercised…the difference between them will be the premium on the option(your profit or loss if you exercise the option)
      stocks only have the market price, no strike price…

      is that what you were asking?

    • edulima
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      Thank you @Pranav. No, that’s not exactly what I was asking. I understand that stocks don’t have strike prices, but both options and stocks have market prices (the market price of the option is the amount one can get by selling the option itself; so it would be higher if the option is in-the-money and lower, or even zero, if the option is out-of-the-money), so that’s why the original phrase is confusing (and perhaps incorrect!). What I meant was that the phrase should read “reflecting the difference between the strike price of the option and the market price of the stock“…

    • Pranav
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      why do you think it should be option and stock, not just option, in that statement?

      below is my understanding on what would happen in both the scenarios, read at your own peril 😛

      this is september…let’s consider the example of an option that expires in september…
      the market price of this option will closely follow or match with the market price of the stock…so the tax deductions should be equivalent whether it is stock or option in that statement…
      what you are suggesting will make an impact if we consider an option that expires in november, let’s say..
      assuming that the market price of the stock is volatile currently and is fluctuating quite a bit, the november option will not proportionally follow that fluctuation/volatility…in such a scenario, if the statement is “strike price of the option and the market price of the stock”, undue advantage can be taken in the markets on options with low volatility, thus making them more volatile…

      the above is just a guess, i am hopeful one of the experts will step in and correct me now 🙂

    • Pranav
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      @edulima, forgot to tag you

    • Sophie Macon
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      @edulima – I agree with you. that looks a little odd to me, although not mentioned in the errata of CFAI. I assume you’re using CFAI reference book for this?

    • edulima
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      Thanks @Sophie. Yes, I am using the CFAI book. I’ll send an email with this comment to the curriculum development folks at the CFAI. Perhaps I’ll get a prize 😉

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