LiquidAssets10

How is the option-adjusted spread (OAS) computed using the Monte Carlo simulation model? The OAS is the value of the spread that, when added to all of the simulated spot rates, makes the:

A) average of the present values from the simulated cash flow paths equal to the market price of the mortgage-backed security.

B) present value of cash flows equal to the market price of the mortgage-backed security.

C) theoretical present value, assuming a constant prepayment rate, equal to the market price of the mortgage-backed security.

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The option adjusted spread for the Monte Carlo model is the spread that must be added to all of the spot rates along each interest rate path that will make the average present value of the path cash flows equal to the market price (plus accrued interest) for the MBSs being evaluated.

LiquidAssets10

If the simulated interest rates are based on the Treasury curve, then how is the option-adjusted spread obtained (OAS) using the Monte Carlo simulation model interpreted? The OAS is the:

A) spread over the Treasury spot rate corresponding to the maturity of the mortgage-backed security.

B) average spread over the Treasury yield.

C) average spread over the Treasury spot rate curve.

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The monthly rates along the paths generated with the Monte Carlo simulation model using the Treasury yield curve as a benchmark are Treasury spot rates that have been adjusted to be arbitrage-free. As such, the OAS measures the average spread over Treasury spot rates, not the Treasury yield.

LiquidAssets10

The spread (k) that must be added to all of the spot rates along each interest rate path that will force equality between the average present value of the path’s cash flows and the market price (plus accrued interest) for the mortgage-backed security (MBS) being evaluated is called the:

A) PAC spread.

B) k-spread.

C) option-adjusted spread (OAS).

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The spread (k) that must be added to all of the spot rates along each interest rate path that will force equality between the average present value of the path’s cash flows and the market price (plus accrued interest) for the MBS being evaluated is called the OAS.

LiquidAssets10

Wanda Brunner, CFA, is evaluating two tranches of a sequential-pay CMO structure.

Tranche	OAS (bps)	Z-spread (bps)	Effective duration
I	95	100	4.25
II	90	100	4.25

How should Brunner trade these CMO tranches?

A) Buy Tranche II and sell Tranche I.

B) Cannot be determined.

C) Buy Tranche I and sell Tranche II.

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Tranche I option cost = 100 – 95 = 5 basis points
Tranche II option cost = 100 – 90 = 10 basis pointsTranche I has a higher OAS and lower option cost than Tranche II, and the effective durations of the two tranches are equal. Therefore:

• Tranche I is undervalued on a relative basis (“cheap”), and she should buy it.
• Tranche II is overvalued on a relative basis (“rich”), and she should sell it.

LiquidAssets10

Generally speaking, an analyst would like the adjusted spread (OAS) to be:

A) small.

B) big.

C) zero.

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Generally speaking, an analyst would like the OAS to be big.

LiquidAssets10

The major differences in effective duration among analytical systems providers are attributable to all of the following assumptions EXCEPT:

A) option adjusted spread (OAS) differences.

B) differences in changes in interest rates.

C) mortgage-rate differences.

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Mortgage rate differences do not cause effective duration differences among analytical system providers.

LiquidAssets10

Paul Wilken works in the structured product group of a large investment bank. One of his new tasks is to perform valuation analysis on mortgage-backed (MBS) and asset-backed securities (ABS). Wilken needs to familiarize himself with the many measures used to value these types of securities. The first valuation metric that Wilken is to explore is the cash flow yield. Wilken would like to determine the strengths and weaknesses of the cash flow yield. Which of the following assumptions is least likely a limitation of the cash flow yield measure?

A) The computation includes an assumption about the default rate of the underlying loans.

B) The credit risk associated with the underlying loans is constant over the life of the security.

C) MBS or ABSs are held until the final payout based on some prepayment assumption.

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The cash flow yield measure does not rely on any credit risk assumption. (Study Session 15, LOS 53.a)

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Wilken now turns his attention to the nominal spread. Once again he is interested in the strengths and weaknesses of the valuation metric. Which of the following is a limitation of the nominal spread? The nominal spread:

A) contains no adjustment for prepayment risk.

B) is not adjusted for interest rate risk.

C) does not account for inflation.

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The nominal spread does not properly capture the prepayment risk associated with these securities. (Study Session 15, LOS 53.a)

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Wilken has some experience using interest rate lattice models to price interest rate derivatives. He has read that the lattice based backward induction method cannot be used to value a MBS. Which of the following is a reason why this is the case? The lattice based backward induction method is difficult to use because of:

A) prepayments.

B) variable interest rates.

C) the path dependency of cash flows.

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Prepayments depend on the level of the interest rate at a particular point in time and also on the path the interest rate has taken in order to get to a certain level. Backward induction can't easily capture path dependent cash flows.
Prepayments can be incorporated in a model that uses backward induction. (Study Session 15, LOS 53.c)

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Wilken wants to use Monte Carlo simulation in order to value agency passthrough securities. Why must adjustments be made to interest rate paths of the Monte Carlo simulation model? Adjustments must be made to:

A) ensure that the correct prepayments are included.

B) produce the requisite no-arbitrage property.

C) prevent defaults.

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The user must adjust the interest rate paths so that the model retains a no-arbitrage with market values. (Study Session 15, LOS 53.b)

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Wilken turns his attention to interest rate sensitivity measures. In particular he wants to know why there are differences in effective duration quotes between dealer firms. Which of the following is least likely a reason why there exist differences in the effective duration measures in the MBS and ABS markets? Suppliers of effective duration quotes use different:

A) OASs.

B) prepayment models.

C) convexity estimates.

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The convexity metric is not needed to compute the effective duration. (Study Session 15, LOS 53.f)

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Wilken is aware that there are different methods to value an ABS. When should an ABS be valued using the zero-volatility spread approach?

A) When the ABS does not have a prepayment option or the prepayment option is unlikely to be exercised.

B) When the ABS has a prepayment option that is likely to be exercised.

C) When there is no default risk.

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This approach does not consider any prepayment option. (Study Session 15, LOS 53.i)

LiquidAssets10

Which of the following is NOT a major reason why the effective durations reported by dealers and vendors can be very different?

A) Differences in the assumption how yield volatility changes for shocks to the yield curve.

B) Different option-adjusted spreads.

C) Differences in the relationship between short-term interest rates and refinancing rates.

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The major differences in the effective duration among analytical systems providers are attributable to differences in the following: the incremental change in interest rate, the prepayment model, the OAS, and the interest rate/refinancing rate spread assumption.

LiquidAssets10

Why do differences in the size of the rate shock produce different effective durations?

A) The yield curve is not flat.

B) Different rate shocks result in different yield volatility changes.

C) The price-yield relationship is convex.

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If the incremental change in interest rates is too large, the effects of convexity contaminate duration measurements.

LiquidAssets10

The option adjusted spread (OAS) is used to analyze risk by adjusting for the embedded options. Which of the following risks does the OAS reflect?

A) Credit risk.

B) Prepayment risk.

C) Maturity risk.

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The OAS reflects credit risk and liquidity risk.