LiquidAssets10

All of the following are advantages of coupon curve duration EXCEPT it:

A) presumably reflects market expectations.

B) is easy to apply.

C) is limited to generic mortgage-backed securities (MBS).

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It is a disadvantage that it is limited to generic MBS and is not readily applicable to collateralized mortgage obligations (CMO) structures.

LiquidAssets10

Which of the following is a limitation of cash flow duration?

A) It assumes a single prepayment rate over the life of the mortgage backed security.

B) It assumes that the cash flows do not change for a given interest rate shock.

C) It does not take credit risk into account.

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A major criticism of cash flow duration is that it is based on the unrealistic assumption that a single prepayment rate exists over the life of an MBS for any given change in interest rates. The Monte Carlo simulation does allow for changing prepayment rates, and, therefore, effective duration computed using the Monte Carlo simulation is much better than cash flow duration for MBSs

LiquidAssets10

All of the following are disadvantages of empirical duration EXCEPT:

A) the volatility of the spreads with reference to Treasuries can distort the price reaction to interest rate changes.

B) time series data on mortgage-backed securities may be difficult to obtain.

C) it has no theoretical underpinnings or analytical assumptions.

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The fact that it has no theoretical underpinnings or analytical assumptions is an advantage of empirical duration, not a disadvantage.

LiquidAssets10

Which of the following is least likely an advantage of the empirical duration approach?

A) The volatility of the spread to Treasury securities does not distort how the price of mortgage-backed securities (MBS) reacts to yield changes.

B) The only inputs needed are prices and Treasury yields.

C) It does not rely on any theoretical formulas or assumptions.

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The fact that the volatility of the spreads with reference to Treasuries can distort the price reaction to interest rate changes is a criticism of the empirical duration approach.

LiquidAssets10

The cash flows from mortgage-backed and some asset-backed securities are:

A) virtually free of prepayment risk.

B) interest rate path dependent.

C) interest rate path independent.

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The cash flows from mortgage-backed and some asset-backed securities are interest-rate path dependent.

LiquidAssets10

For a bond with an embedded option where the cash flows are not interest rate path dependent, which of the following valuation approaches should be used?

A) The option-adjusted spread approach with the binomial model.

B) The zero-volatility spread approach with the binomial model.

C) The option-adjusted spread approach with the Monte Carlo simulation model.

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The OAS method recognizes that cash flow changes accompany interest rate changes. Thus, it is suitable to use OAS analysis with ABSs that have a prepayment option that is frequently exercised, and if the cash flows are independent of the interest rate path, OAS should be computed with the binomial model.

LiquidAssets10

With the zero volatility spread (Z-spread) approach the value of an asset-backed security (ABS) is the present value of cash flows discounted at the spot rates plus the Z-spread. This means the Z-spread technique does not incorporate prepayments and thus would be appropriate to value:

A) high quality home equity loans.

B) auto loans or credit card loans.

C) auto loans or high quality home equity loans.

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The Z-spread would be appropriate for valuing auto or credit card backed securities, because neither are likely to refinance.

LiquidAssets10

When should an asset-backed security (ABS) be valued using the option-adjusted spread (OAS) approach?

A) To value ABS that have a prepayment option.

B) To value ABS that do not have a prepayment option.

C) For agency ABS.

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The OAS method recognizes that cash flow changes accompany interest rate changes. Thus, it is suitable to use OAS analysis with ABSs that have a prepayment option that is frequently exercised, e.g., high quality home equity loans.

LiquidAssets10

When is it best for an asset-backed security (ABS) to be valued using the zero-volatility spread approach?

A) To value ABS that have a prepayment option.

B) To value ABS that do not have a prepayment option.

C) For agency ABS.

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With the zero-spread method, the value of an ABS is the present value of its cash flows discounted at the spot rates plus the zero-volatility spread. The Z-spread technique does not incorporate prepayments. Thus, it should only be used for ABSs for which the borrower either has no option to prepay, or is unlikely to.

LiquidAssets10

For a bond with an embedded option where the cash flow is interest rate path dependent, which of the following valuation approaches should be used?

A) The nominal spread approach with the Monte Carlo simulation model.

B) The option-adjusted spread approach with the binomial model.

C) The option-adjusted spread approach with the Monte Carlo simulation model.

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The OAS method recognizes that cash flow changes accompany interest rate changes. Thus, it is suitable to use OAS analysis with ABSs that have a prepayment option that is frequently exercised, and, if the cash flows are dependent upon the interest rate path, OAS should be computed with the Monte Carlo simulation model.