dkishore1

A callable bond and an option-free bond have the same coupon, maturity and rating. The callable bond currently trades at par value. Which of the following lists correctly orders the values of the indicated items from lowest to highest?

A) $0, embedded call, callable bond, option-free bond.

B) Embedded call, callable bond, $0, option-free bond.

C) Embedded call, $0, callable bond, option-free bond.

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The embedded call will always have a positive value prior to expiration, and this is especially true if the callable bond trades at par value. Since investors must be compensated for the call feature, the value of the option-free bond must exceed that of a callable bond with the same coupon and maturity and rating.

dkishore1

A callable bond, a putable bond, and an option-free bond have the same coupon, maturity and rating. The call price and put price are 98 and 102 respectively. The option-free bond trades at par. Which of the following lists correctly orders the values of the three bonds from lowest to highest?

A) Callable bond, option-free bond, putable bond.

B) Option-free bond, putable bond, callable bond.

C) Putable bond, option-free bond, callable bond.

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The put feature increases the value of a bond and the call feature lowers the value of a bond, when all other things are equal. Thus, the putable bond generally trades higher than a corresponding option-free bond, and the callable bond trades at a lower price.

dkishore1

As the volatility of interest rates increases, the value of a callable bond will:

A) rise.

B) rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate.

C) decline.

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As volatility increases, so will the option value, which means the value of a callable bond will decline. Remember that with a callable bond, the investor is short the call option.

dkishore1

On a given day, a bond with a call provision rose in value by 1%. What can be said about the level and volatility of interest rates?

A) The only possible explanation is that level of interest rates fell.

B) A possibility is that the level of interest rates remained constant, but the volatility of interest rates fell.

C) A possibility is that the level of interest rates remained constant, but the volatility of interest rates rose.

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As volatility declines, so will the option value, which means the value of a callable bond will rise.

dkishore1

As the volatility of interest rates increases, the value of a putable bond will:

A) rise.

B) decline.

C) rise if the interest rate is below the coupon rate, and fall if the interest rate is above the coupon rate.

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As volatility increases, so will the option value, which means the value of a putable bond will rise. Remember that with a putable bond, the investor is long the put option.

dkishore1

Which part of the nominal spread does the option-adjusted spread (OAS) capture?

A) credit and liquidity risk.

B) interest rate and volatility risk.

C) option risk.

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The OAS removes the amount that is due to option risk from the nominal spread leaving just the credit and liquidity risk.

dkishore1

Which kind of risk remains if the option-adjusted spread is deducted from the nominal spread?

A) credit risk.

B) option risk.

C) liquidity risk.

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The OAS captures the amount of credit risk and liquidity risk.

dkishore1

An analyst has constructed an interest rate tree for an on-the-run Treasury security. Given equal maturity and coupon, which of the following would have the highest option-adjusted spread?

A) A putable corporate bond with a AAA rating.

B) A putable corporate bond with a Aaa rating.

C) A callable corporate bond with a Baa rating.

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The bond with the lowest price will have the highest option-adjusted spread. All other things equal, the callable bond with the lowest rating will have the lowest price.

dkishore1

Which of the following correctly explains how the effective duration is computed using the binomial model. In order to compute the effective duration the:

A) binomial tree has to be shifted upward and downward by the same amount for all nodes.

B) yield curve has to be shifted upward and downward in a parallel manner and the binomial tree recalculated each time.

C) the nodal probabilities are shifted upward and downward and the binomial tree recalculated each time.

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Apply parallel shifts to the yield curve and use these curves to compute new forward rates in the interest rate tree. The resulting bond values are then used to compute the effective duration.

dkishore1

Which of the following most accurately explains how the effective convexity is computed using the binomial model. In order to compute the effective convexity the:

A) yield curve has to be shifted upward and downward in a parallel manner and the binomial tree recalculated each time.

B) binomial tree has to be shifted upward and downward by the same amount for all nodes.

C) volatility has to be shifted upward and downward and the binomial tree recalculated each time.

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Apply parallel shifts to the yield curve and use these curves to compute new forward rates in the interest rate tree. The resulting bond values are then used to compute the effective convexity.