@michael_in_scotland
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Up4
Maybe this will help. Imagine both firms’ shares would be fairly priced at $10 if there is NO interest rate reduction, and $20 if there IS a reduction. Think about how our view of the probability of a rate reduction would effect the amount we’d pay for a share in either company. If we thought a rate reduction was 50% likely, then we’d pay $15 for either share; if we thought it was 25% likely, we’d pay $12.50, if we thought it was 100% likely then we’d be willing to pay the whole $20, and so on. (This is a bit simplistic but I think the point should be clear.)
Given all that, it appears from the question that shares in firm A must currently be trading at $17.50, and shares in firm B must be at $14, even though both have the same intrinsic value regardless of whether the rate reduction does or does not happen. So now, imagine if you shorted A at $17.50 and bought B at $14:
– If the rate reduction does happen, both firms will increase to $20, because that is the fair value of both if the rate rise occurs. You’ll lose on A (- $2.50/14% ), but you’ll gain more on B (+ $6/43%).
– On the other hand, if the rate reduction does not happen, both firms will drop to $10. You’ll lose on B (- $4/29%), but you’ll gain more on A (+ $7.50/43%).
Either way you make a profit.
You can work out the exact numbers to convince yourself! You should also be able to see that the exact prices don’t matter – I just used $10 and $20 for both companies to make the example simpler.
Up3Hi…I’m also from Scotland, although I’m a recent arrival from Australia. Just took the level 1 exam in June; finished a part-time master’s degree in finance while working back in Australia last year so luckily some material was still fresh in my mind!
I did a lot of lurking on the forum while studying and found it really helpful, so I figure I should try and give something back now.
Up3On DOL I think you are confusing percentage changes with $ figure changes.
DOL of 3.5 means that for a 20% drop in sales, you’ll experience a 20% * DOL = 20% * 3.5 = 70% drop in EBIT.
I think if you re-do your calculations using the ratio of percentages you’ll get a more sensible answer.
Up2Glad it made sense!
Up1Moved to sunny (well, it is today) Edinburgh earlier in the year when my partner got a job here, so I was able to spend a solid ten weeks focussed on L1 prep while I settled in here. That might not seem like a lot of time calendar-wise, but I was able to devote at least 3-4 ‘high quality’ hours each weekday to study, including LOTS of practice questions. (There’s a big hint as to my one piece of advice!) We shall see next week if it was sufficient! Had I been working I would have wanted 4+ months, and that’s with a reasonable level of background knowledge.
Once L1 was done it was job-hunting time. Now I am waiting on background checks before I start work. I may sit L2 next June – I need to see what the demands on my time are like once I settle back into work and various other commitments.
Feel free to drop me a line if you have any questions. Are you in Edinburgh or over West?
Up1Yes I think I might just have to wait one more day! ~X(
