LOS b: Evaluate the importance of the benchmark interest rates in interpreting spread measures.

Q1. Which of the following benchmarks would generate the greatest spread when used to examine a bond yield?

A)   Bond sector benchmark.

B)   The issuer of a specific company.

C)   A U.S. Treasury security.

Q2. Which of the following spreads will reflect the option risk in a callable bond?

A)   Both the nominal spread and the Z-spread.

B)   The Z-spread only.

C)   The OAS only.

Q3. The use of which of the following benchmarks to generate a spread would not reflect credit risk?

A)   A U.S. Treasury benchmark.

B)   A global industry-yield benchmark.

C)   An issuer-specific benchmark.

LOS b: Evaluate the importance of the benchmark interest rates in interpreting spread measures. fficeffice" />

Q1. Which of the following benchmarks would generate the greatest spread when used to examine a bond yield?

A)   Bond sector benchmark.

B)   The issuer of a specific company.

C)   A U.S. Treasury security.

Correct answer is C)

The U.S. Treasury security would generate the highest spread because the yield on Treasury securities will be the lowest as they have the lowest credit and liquidity risk. The yields on a bond sector benchmark and for a specific company will be higher.

Q2. Which of the following spreads will reflect the option risk in a callable bond?

A)   Both the nominal spread and the Z-spread.

B)   The Z-spread only.

C)   The OAS only.

Correct answer is A)

The OAS is the option-adjusted spread. It is determined using a binomial tree where a spread (the OAS) is added to the benchmark yield to find the arbitrage-free value for the callable or putable bond. The arbitrage-free value is the imputed value equal to the current bond price. The OAS is referred to as an option-adjusted spread because the cash flows in the tree are adjusted to reflect the option of the bond (e.g. a callable bond’s price is capped at the call price when interest rates drop). The nominal spread is simply the bond’s yield minus the benchmark yield. The Z-spread is the spread that, when added to the spot rates from a yield curve, results in an imputed value equal to the bond’s current price. The nominal spread and the Z-spread do not adjust the cash flows for the bond’s option. Thus the calculated yield spread using both these measures will reflect the option risk in the bond, as well as the bond’s credit and liquidity risk. Because the OAS calculation adjusts the cash flows for the bond’s option-like characteristics, the calculated OAS is just a reflection of the bond’s credit and liquidity risk, relative to the benchmark spot rates.

Q3. The use of which of the following benchmarks to generate a spread would not reflect credit risk?

A)   A U.S. Treasury benchmark.

B)   A global industry-yield benchmark.

C)   An issuer-specific benchmark.

Correct answer is C)

An issuer-specific benchmark (another bond of the same company) would not reflect credit risk because the benchmark would incorporate the credit risk of the firm. Using a U.S. Treasury benchmark would reflect credit risk because the bond to be evaluated would have higher credit risk than either benchmark. The yield in a global industry is not typically used as a benchmark.

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