Question #6 - 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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- 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? 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)

Question

Which of the two bonds Woods is considering purchasing has the greater interest rate exposure?

Answer Choices:

A. ARM B, because it has a smaller duration

B. The interest rate exposure cannot determine without a specific measure of convexity

C. ARM A, because it has a larger duration. Explanation Effective duration is a measure of interest rate risk. All things equal, the larger the duration of a security the greater the interest rate risk. (Module 27.4, LOS 27.g)

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