Question #96 - 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

- Puldo still believes that Diffle must include the OAS for the Hardin bonds in his report. Puldo points out that a proper benchmark is critical to any OAS analysis. Which of the following statements regarding benchmark interest rates and OAS is most accurate? Since liquidity risk is a critical issue, the OAS calculation for the Hardin bonds should: duration = convexity = V−−V+ 2 x V0 x Δy V+ + V−− 2V0 2 x V0 x(Δy)2 A) use on-the-run U.S. Treasury rates as a benchmark in order to isolate the credit risk of the Hardin bonds. B) use on-the-run interest rates for other callable Hardin bonds as a benchmark in order to isolate the liquidity risk of the 2-year bond issue. C) be based on a benchmark that has no credit risk. Explanation By using on-the-run rates of the issuing company, there will be no difference in credit risk captured in the spread. The only risk left will be liquidity risk. Using on-the-run U.S. Treasury rates is incorrect because using U.S. Treasury rates would not isolate the credit risk since liquidity risk would also be included. Using a benchmark that has no credit risk would not help differentiate the Hardin bonds from the Bratton bonds. (Module 27.4, LOS 27.g)

Question

Which of the following statements is most accurate regarding Diffle's calculation of duration and convexity?

Answer Choices:

A. The duration estimate will be inaccurate since it does not account for any change in cash flows due to the call option embedded in the Hardin bond

B. The estimates for both duration and convexity will be inaccurate because the OAS was not estimated again after the rate shock

C. The duration estimate for the Bratton bonds will reflect the projected percentage change in price for a 100-basis-point change in interest rates. Explanation The duration formula given will calculate the percentage change in price for a 100 basis point change in yield, regardless of the actual change in rates used to derive BV– and BV+. The standard backward induction process would ensure that the derived values of BV– and BV+ reflect any potential change in cash flows due to embedded options. (Module 27.6, LOS 27.l)

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