LOS f: Differentiate between the nominal spread, the zero-volatility spread, and the option-adjusted spread.

Q1. Which of the following statements regarding the option adjusted spread (OAS) is least accurate? The option adjusted spread:

A)   is the spread added to the Treasury spot rate curve that the bond would have if it were option-free.

B)   is the spread that accounts for non-option characteristics like credit risk, liquidity risk, and interest rate risk

C)   for a putable bond is the Z-spread minus the cost of the option.

Q2. The zero volatility spread (Z-spread) is the spread that:

A)   is added to each spot rate on the Treasury yield curve that will cause the present value of the bond's cash flows to equal its market price.

B)   is added to the yield to maturity of a similar maturity Treasury bond to equal the yield to maturity of the risky bond.

C)   results when the cost of the call option in percent is subtracted from the option adjusted spread.

Q3. One of the most commonly used yield spread measures is the nominal spread. Which of the following is a limitation of nominal spread? The nominal spread assumes:

A)   an upward sloping yield curve.

B)   all coupon payments are reinvested at a rate equal to the risk free rate.

C)   a flat yield curve.

Q4. One of the most commonly used yield spread measures is the nominal spread. Which of the following is NOT a limitation of nominal spread? The nominal spread:

A)   assumes a flat yield curve.

B)   is difficult to calculate.

C)   assumes all cash flows can be discounted at the same rate.

Q5. The zero volatility spread (Z-spread) is the spread that:

A)   is added to the yield to maturity of a similar maturity Treasury bond to equal the yield to maturity of the risky bond.

B)   is added to each spot rate on the Treasury yield curve that will cause the present value of the bond's cash flows to equal its market price.

C)   results when the cost of the call option in percent is subtracted from the option adjusted spread.

Q6. One of the most commonly used yield spread measures is the nominal spread. Which of the following is least likely a limitation of nominal spread? The nominal spread assumes:

A)   an upward sloping yield curve.

B)   all cash payments will be received in a prompt and timely manner.

C)   all cash flows can be discounted at the same rate.

LOS f: Differentiate between the nominal spread, the zero-volatility spread, and the option-adjusted spread.fficeffice" />

Q1. Which of the following statements regarding the option adjusted spread (OAS) is least accurate? The option adjusted spread:

A)   is the spread added to the Treasury spot rate curve that the bond would have if it were option-free.

B)   is the spread that accounts for non-option characteristics like credit risk, liquidity risk, and interest rate risk

C)   for a putable bond is the Z-spread minus the cost of the option.

Correct answer is C)

Since the buyer of a putable bond must pay extra for the put option, the OAS spread for a putable bond is the Z-spread plus the put option cost in percent.

Q2. The zero volatility spread (Z-spread) is the spread that:

A)   is added to each spot rate on the Treasury yield curve that will cause the present value of the bond's cash flows to equal its market price.

B)   is added to the yield to maturity of a similar maturity Treasury bond to equal the yield to maturity of the risky bond.

C)   results when the cost of the call option in percent is subtracted from the option adjusted spread.

Correct answer is A)

The zero volatility spread (Z-spread) is the interest rate that is added to each zero-coupon bond spot rate that will cause the present value of the risky bond's cash flows to equal its market value. The nominal spread is the spread that is added to the YTM of a similar maturity Treasury bond that will then equal the YTM of the risky bond. The zero volatility spread (Z-spread) is the spread that results when the cost of the call option in percent is added to the option adjusted spread.

Q3. One of the most commonly used yield spread measures is the nominal spread. Which of the following is a limitation of nominal spread? The nominal spread assumes:

A)   an upward sloping yield curve.

B)   all coupon payments are reinvested at a rate equal to the risk free rate.

C)   a flat yield curve.

Correct answer is C)        

The nominal spread is easy to calculate – it is simply the yield to maturity on a bond minus the yield to maturity on a Treasury security of a similar maturity. Because the nominal yield is based on the yield to maturity, it suffers the same shortcomings as yield to maturity. The yield measures assume that all cash flows can be discounted at the same rate (i.e., assumes a flat yield curve). They also assume that all coupon payments will be received in a prompt and timely fashion, and reinvested to maturity, at a rate of return that is equal to the appropriate solving rate (i.e., the bond’s YTM or its BEY).

Q4. One of the most commonly used yield spread measures is the nominal spread. Which of the following is NOT a limitation of nominal spread? The nominal spread:

A)   assumes a flat yield curve.

B)   is difficult to calculate.

C)   assumes all cash flows can be discounted at the same rate.

Correct answer is B)

The nominal spread is easy to calculate – it is simply the yield to maturity on a bond minus the yield to maturity on a Treasury security of a similar maturity. Because the nominal yield is based on the yield to maturity, it suffers the same shortcomings as yield to maturity. The yield measures assume that all cash flows can be discounted at the same rate (i.e., assumes a flat yield curve). They also assume that all coupon payments will be received in a prompt and timely fashion, and reinvested to maturity, at a rate of return that is equal to the appropriate solving rate (i.e., the bond's YTM or its BEY).

Q5. The zero volatility spread (Z-spread) is the spread that:

A)   is added to the yield to maturity of a similar maturity Treasury bond to equal the yield to maturity of the risky bond.

B)   is added to each spot rate on the Treasury yield curve that will cause the present value of the bond's cash flows to equal its market price.

C)   results when the cost of the call option in percent is subtracted from the option adjusted spread.

Correct answer is B)

The zero volatility spread (Z-spread) is the interest rate that is added to each zero-coupon bond spot rate that will cause the present value of the risky bond's cash flows to equal its market value. The nominal spread is the spread that is added to the YTM of a similar maturity Treasury bond that will then equal the YTM of the risky bond. The zero volatility spread (Z-spread) is the spread that results when the cost of the call option in percent is added to the option adjusted spread.

Q6. One of the most commonly used yield spread measures is the nominal spread. Which of the following is least likely a limitation of nominal spread? The nominal spread assumes:

A)   an upward sloping yield curve.

B)   all cash payments will be received in a prompt and timely manner.

C)   all cash flows can be discounted at the same rate.

Correct answer is A)

The nominal spread is easy to calculate – it is simply the yield to maturity on a bond minus the yield to maturity on a Treasury security of a similar maturity. Because the nominal yield is based on the yield to maturity, it suffers the same shortcomings as yield to maturity. The yield measures assume that all cash flows can be discounted at the same rate (i.e., assumes a flat yield curve). They also assume that all coupon payments will be received in a prompt and timely fashion, and reinvested to maturity, at a rate of return that is equal to the appropriate solving rate (i.e., the bond’s YTM or its BEY).

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