Question #5 - Reading 27 Valuation and Analysis of Bonds With Embedded Options

Reading: Reading 27 Valuation and Analysis of Bonds With Embedded Options - Anwers

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Shared Context

- Woods is most likely resistant to the zero-volatility spread because the spread: A) only considers one path of interest rates, the current Treasury spot rate curve. B) fails to consider price risk, which is uncertainty regarding terminal cash flows. C) does not indicate how much of the spread reflects the significant prepayment risk associated with MBS. Explanation Zero-volatility spread is a commonly used measure of relative value for MBS and ABS. However, it only considers one path of interest rates, while OAS considers every spot rate along every interest rate path. (Module 27.4, LOS 27.g)

Question

In general, the investment team at Matrix attempts to buy "cheap" securities because they are undervalued on a relative basis. What is a characteristic of a "cheap" security for a given Z-spread and effective duration?

Answer Choices:

A. High OAS relative to the required OAS and high option costs

B. High OAS relative to the required OAS and low option costs

C. Low OAS relative to the required OAS and low option costs. Explanation A higher OAS indicates a larger risk-adjusted spread, which leads to a lower relative price. The implied cost of the embedded option in a security with a call feature is the option cost, so a buyer would prefer a lower cost. (Module 27.4, LOS 27.g)

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