Question #56
Reading: Reading 27 Valuation and Analysis of Bonds With Embedded Options - Anwers
PDF File: Reading 27 Valuation and Analysis of Bonds With Embedded Options - Anwers.pdf
Page: 24
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Part of Context Group: Q56-57
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Question
Which of the following is most accurate regarding the use of a binomial tree to calculate the option adjusted spread (OAS) of bonds with embedded options?
Answer Choices:
A. The binomial tree can be used to calculate the OAS of a callable corporate bond but not a mortgage backed security (MBS), as the MBS does not contain an option
B. The spot rate curve cannot be used to calculate the OAS of a callable corporate bond but can be used for a mortgage backed security (MBS)
C. The binomial tree can be used to calculate the OAS of a callable corporate bond but not a mortgage backed security (MBS), as the MBS value is path dependent. Explanation OAS on callable or putable bonds can be calculated using binomial interest rate trees. MBS has a prepayment risk, and hence has an embedded call option. Binomial interest rate tree cannot be used to value MBS as the prepayment risk (call risk) in MBS is path dependent. Spot rate curve comprises a single rate for each time period and hence cannot be used to value securities with embedded options. If spot rate curve is used, implicitly you would be assuming zero volatility in rates, and therefore end up valuing the time value component of the option value as zero. (Module 27.4, LOS 27.h)
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