Is a discount bond consider risk free security? concerning, security, following, discount, statements

nixie24

Hi,

this is one of a question in qbank. I like to seek advice if a discount bond is consider a risk free security as option C is stated as a correct ans in this question.

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Which of the following statements concerning arbitrage-free bond prices is NOT correct?

A) Credit spreads are affected by time to maturity.

B) It is not possible to strip coupons from U.S. Treasuries and resell them.

C) The determination of spot rates is usually done using risk-free securities.


Your answer: B The correct answer was B) It is not possible to strip coupons from U.S. Treasuries and resell them.

It is possible to both strip coupons from U.S. Treasuries and resell them, as well as to aggregate stripped coupons and reconstitute them into U.S. Treasury coupon bonds. Therefore, arbitrage arguments ensure that U.S. Treasury securities sell at or very near their arbitrage free values. For valuing non-Treasury securities, a credit spread is added to each treasury spot yields. The credit spread is a function of default risk and the term to maturity.
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I'm do not understand the answer for option C. At Book 5 LOS.63d, it state that spot rates are the discount rates for zero coupon bonds, securities that have only a single cashflow at future date.

So is a discount bond consider risk free security?

Thanks

waldziuchna

Risk free in this case is speaking about Government bonds, since they do not have default risk. So yes, a zero coupon bond which is a Government bond would be issued at a discount and would be risk free.

I think you are thinking about whether or not you would use a zero coupon bond as a risk free bond to calculate CAPM. I think the answer would be yes if it were the only bond available at the required maturity you were seeking. However, I doubt there will be a question on the exam that will give you two similar risk free bonds and ask you to choose one.

Maybe someone with more knowledge can further explain.

orang3eph

I would say the US govt essentially does sell discount instruments out to 30 years because stripping bonds is done through the Treasury program unlike in the early years when banks set up trusts and did it themselves. "Risk-free" usually does not include reinvestment risk - it generally just means "default risk free".

And if Treasuries are risk free how come there is an active market in CDS for them?

invic

I meant Treasury Discount instruments are free of default risk and reinvestment risk.