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Sharon Rogner, CFA is evaluating three bonds for inclusion in fixed income portfolio for one
of her pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years
and are generally identical in every respect except that bond A is an option-free bond, bond
B is callable in two years and bond C is putable in two years. Rogner computes the OAS of
bond A to be 50bps using a binomial tree with an assumed interest rate volatility of 15%.
If Rogner revises her estimate of interest rate volatility to 10%, the computed OAS of Bond C
would most likely be:
A) equal to 50bps.
B) higher than 50bps.
C) lower than 50bps.
MediSoft Inc. develops and distributes high-tech medical software used in hospitals and clinics across the United States and Canada. The
firm's software provides an integrated solution to monitoring, analyzing, and managing output from a variety of diagnostic medical
equipment including MRIs, CT scans, and EKG machines. MediSoft has grown rapidly since its inception ten years ago, averaging 25%
growth in sales over the past decade. The company went public three years ago. Twelve months after its IPO, MediSoft made two
semiannual coupon bond offerings, the first of which was a convertible bond. At the time of issuance, the convertible bond had a coupon
rate of 7.25%, a par value of $1,000, a conversion price of $55.56, and ten years until maturity. Two years after issuance, the bond became
callable at 102% of par value. Soon after the issuance of the convertible bond, the company issued another series of bonds, which were
putable but contained no conversion or call features. The putable bonds were issued with a coupon of 8.0%, a par value of $1,000, and 15
years until maturity. One year after their issuance, the put feature of the putable bonds became active, allowing the bonds to be put at a
price of 95% of par value, and increasing linearly over five years to 100% of par value. MediSoft's convertible bonds are now trading in the
market for a price of $947 with an estimated straight value of $917. The company's putable bonds are trading at a price of $1,052. Volatility
in the price of MediSoft's common stock has been relatively high over the past few months. Currently, the stock is priced at $50 on the New
York Stock Exchange and is expected to continue its annual dividend in the amount of $1.80 per share.
High-tech industry analysts for Brown & Associates, a money management firm specializing in fixed-income investments, have been closely
following MediSoft ever since it went public three years ago. In general, portfolio managers at Brown & Associates do not participate in
initial offerings of debt investments, preferring instead to see how the issue trades before considering taking a position in the issue.
Because MediSoft's bonds have had ample time to trade in the marketplace, analysts and portfolio managers have taken an interest in the
company's bonds. At a meeting to discuss the merits of MediSoft's bonds, the following comments were made by various portfolio
managers and analysts at Brown & Associates:
"Choosing to invest in MediSoft's convertible bond would benefit our portfolios in many ways, but the primary benefit is the
limited downside risk associated with the bond. Because the straight value will provide a floor for the value of the convertible
bond, downside risk is limited to the difference between the market price of the bond and the straight value."
"Decreasing volatility in the price of MediSoft's common stock as well as increasing volatility in the level of interest rates are
expected in the near future. The combined effects of these changes in volatility will be a decrease in the price of MediSoft's
putable bonds and an increase in the price of the convertible bonds. Therefore, only the convertible bonds would be a suitable
purchase."