Question #97

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

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Part of Context Group: Q97-98 First in Group
Shared Context
- Which of the following statements is most accurate regarding Diffle's calculation of duration and convexity? 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)
Question
Puldo notes that the duration estimate for the two bonds is not directly comparable. Assuming that the underlying option is at- or near-the-money, the duration of one of the bonds will be lower than the other one. Which of the following most accurately critiques the OAS discussion between Diffle and Puldo? Puldo is:
Answer Choices:
A. correct that the OAS will provide insight into the liquidity risk of the Hardin bonds, and Diffle is correct that different volatility assumptions would change the OAS
B. incorrect that the OAS will provide insight into the liquidity risk of the Hardin Bonds, but Diffle is correct that different volatility assumptions would change the OAS
C. correct that the OAS will provide insight into the liquidity risk of the Hardin Bonds, but Diffle is incorrect since OAS implicitly adjusts for the volatility of interest rates. Explanation The OAS accounts for compensation for credit and liquidity risk after the optionality has been removed (i.e., after cash flows have been adjusted). Since in this case the credit risk of the bonds is similar, the OAS could prove helpful in evaluating the relative liquidity risk. OAS will be affected by different assumptions regarding the volatility of interest rates. (Module 27.4, LOS 27.h)
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