Reading 65:Yield Measures, Spot Rates, and Forward Rates-

statements, following, accounts, adjusted

LOS g: Describe how the option-adjusted spread accounts for the option cost in a bond with an embedded option.

Q1. Kwagmyre Investments, Ltd., hold two bonds: a callable bond issued by Mudd Manufacturing Inc. and a putable bond issued by Precarious Builders. Both bonds have option adjusted spreads (OAS) of 135 basis points (bp). Kevin Grisly, a junior analyst at the firm, makes the following statements (each statement is independent). Apparently, Grisly could benefit from a CFA review course, because the only statement that could be accurate is:

A) Given a nominal spread for Precarious Builders of 110 bp, the option cost is -25 bp.

B) The Z-spread for Mudd's bond is based on the YTM.

C) The spread over the spot rates for a Treasury security similar to Mudd's bond is 145 bp.

Q2. An analyst has gathered the following information:

Bond A is an 11% annual coupon bond currently trading at 106.385 and matures in 3 years. The yield-to-maturity (YTM) for Bond A is 8.50%.
The YTM for a Treasury bond that matures in 3-years is 7.65%.
1, 2, and 3-year spot rates are 5.0%, 6.5% and 8.25%, respectively.

Which of the following statements regarding spreads on bond A is TRUE?

A) The nominal spread is approximately 25 basis points.

B) The Z-spread is approximately 85 basis points.

C) The nominal spread is approximately 85 basis points.

Q3. Which of the following statements on spreads is FALSE?

A) The Z-spread may be used for bonds that contain call options.

B) The Z-spread will equal the nominal spread if the term structure of interest rates is flat.

C) The option-adjusted spread (OAS) is the difference between the Z-spread and the option cost.

Q4. The following information is available for two bonds:

Bond X is callable and has an option-adjusted spread (OAS) of 55bp. Similar bonds have a Z-spread of 68bp and a nominal spread of 60bp.
Bond Y is putable and has an OAS of 100bp. Similar bonds have a Z-spread of 78bp and a nominal spread of 66bp.

The embedded option cost for Bond:

A) X is 5bp.

B) X is 8bp.

C) X is 13bp.