Question #1
Reading: Reading 25 The Term Structure and Interest Rate Dynamics
PDF File: Reading 25 The Term Structure and Interest Rate Dynamics.pdf
Page: 1
Status: Correct
Correct Answer: A
Question
5%, 15-year, annual pay option-free Xeleon Corp bond trades at a market price of $95.72 per $100 par. The government spot rate curve is flat at 5%. Suppose that the Xeleon bond was callable in 10 years at par and an analyst computed the Z-spread on the bond ignoring the embedded option. Relative to the Z-spread on an option- free bond, the calculated Z-spread will most likely be:
Answer Choices:
A. the same
B. higher
C. lower
Explanation
Since a bond with an embedded call option would trade at a lower price than a
comparable option-free bond (i.e., its market price would be lower), the additional spread
needed to force the model value to the (lower) market price will be higher. Because the Z-
spread would inadvertently include compensation for option risk as well as for credit and
liquidity risks, it is not appropriate for valuing bonds with embedded options.