Yield Spreads percentage, difference, statements, following, regarding

edgeon

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Which of the following statements regarding yield spreads is least accurate? The:

A. option cost in percentage terms can be computed by subtracting the OAS from the zero-volatility spread.

B. nominal yield spread measures the difference between the YTM on a risky bond and the YTM on a Treasury bond of similar maturity.

C. The zero volatility spread is the constant spread that is added to each Treasury spot rate to equate the present value of a bond's cash flows to the price of an otherwise identical option-free bond.


Answer:
C. The zero volatility spread is the constant spread that is added to each Treasury spot rate to equate the present value of a bond's cash flows to its actual market price.

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A and B is correct, but I not able to understand the explantion for C. In the question where they state "...bond's cash flows to the price of an otherwise identical option-free bond" - isn't the PRICE assumed to be the market price here? What is the difference between this and the "...bond's cash flows to its actual market price" as they have stated in the answer?

rkapoor

No, that's why they were called r1, .. ,rk. If they were going to be equal I would have called them all r. Would you have preferred if I wrote them with subscripts in HTML? Convince Chad to make the HTML-able and I'm there.

ogoluwa

JoeyDVivre

This was exactly what you wrote: you have called them all r. I copied what you wrote below:

Market price of bond = coupon1/(1 + r + z-spread)^t1 + .... + couponk/(1 + r + z-spread)^tk + principal/(1 + r + z-spread)^tk

I corrected you by adding r1,...rk instead of just r.



Edited 1 time(s). Last edit at Monday, November 15, 2010 at 01:55PM by elcfa.

ramzes

Oops I did miss that. Yep different rates for sure.

nitoha

Nope. The z-spread is a really simple calculation where you take

Market price of bond = coupon1/(1 + r + z-spread)^t1 + .... + couponk/(1 + r + z-spread)^tk + principal/(1 + r + z-spread)^tk

The market price of a bond with an embedded option is different from a bond without an embedded option. Where you are getting messed up is that the z-spread is the spread over treasuries assuming that the bond is held to maturity. A high z-spread can be due to optionality, credit unworthiness, liquidity, taxation, etc..

draz

To be true, c would need to read:
The zero volatility spread is the constant spread that is added to each Treasury spot rate to equate the present value of a bond's cash flows to the market price of the bond.

btcapital

Wait a minute - that's what the answer says. The answer is correct and is different from the wording in the question.