Kwagmyre Investments, Ltd., hold two bonds: a callable bond issued by Mudd Manufacturing Inc. and a putable bond issued by Precarious Builders. Both bonds have option adjusted spreads (OAS) of 135 basis points (bp). Kevin Grisly, a junior analyst at the firm, makes the following statements (each statement is independent). Apparently, Grisly could benefit from a CFA review course, because the only statement that could be accurate is: A) Given a nominal spread for Precarious Builders of 110 bp, the option cost is -25 bp. B) The cost of the call option on the Mudd bond is -15bp. C) The spread over the spot rates for a Treasury security similar to Mudd’s bond is 145 bp. D) The Z-spread for Mudd’s bond is based on the YTM. Ok…I’m lost. Can anybody help me out with this question?
The correct answer was C) The spread over the spot rates for a Treasury security similar to Mudd’s bond is 145 bp. If anybody can help me out with this question, I would be grateful.
I’m in the dark too thought it was A
i have no clue… the formula is z spread - oas = price of the option… a-- is wrong b/c they are giving you the nominal spread not the z spread and since we know both of these bonds have options the nominal is not equal to the z spread… b–cost of a call option is positive z - oas = positive… we get money for the call option… it is better for the buyer they pay us… c-- i have no clue about… d-- the z spread is not based on ytm… so i was left w/ c to choose… and i didnt pick it because i figured if it was something i had no idea about it was a curve ball so i went against my better judgement a setled w/ d… lol i am an idiot… i hope i do not do this on the test
nikko is right about his explanations on a, b, d here is why C is correct – when the question asks “similar treasury” it means coupon and maturity so imagine you have a 5% 10yr callable corporate bond vs a 5% 10yr bullet Treasury. if they are issued at the same price, its cheaper (better value) to buy the bullet since there is no option that can hurt you. in a callable bond you are short the option. SO, if you know the OAS of the callable is 135, the z-spread is going to be higher (since oas + option cost = z-spread). we dont know what it will be, but it will be more than 135. a similar treasury, without the option, will have a spread greater than 135. so C could be right since it COULD be 145
Actually, I believe that the z-spread would be lower given a callable bond because the option cost is Negative. Callable Bond = option free bond - call option Therefore: z-spread = OAS - call option (for callable bond) VS. z-spread = OAS (for treasury bond without option) So, the spread could be 145 for the treasury bond. I think?
I guess I dont understand why it couldnt be B now…UGH, now im confused
thanks mike0021 that is helpful
C is referraling to nominal spread. Since OAS (is really Option removed spread) is 135 for Mudd Bond, the nominal spread must be something higher than 135. nikko0355’s explaination for a, b, d are absolutly correct.
jalmy – zspread = OAS + option cost oas is lower for a bond with a call than its zspread is, meaning if you have 2 securities at the same price, the one with the option will have a lower oas, since that price is too rich compared to the bullet bond
Z-spread=OAS+option cost For callable bonds and most mortgage-backed and asset-backed securities, the option cost is positive. This is because the issuer’s ability to alter cash flows will result in an OAS that is less than Z-spread. C says that a similar Treasury bond has a Z-spread of 145, which can be true given the above explanation.
Pretty bad question. I like A. I don’t like answer C at all because “the spread of a Treasury security” is pretty much 0 since people talk about the spread relative to a risk-free investment of the same maturity. Then there’s the issue of negative costs and who bears these negative costs… Anyway, Precarious is selling a puttable bond so the option cost is (I suppose) negative because the option accrues to the bond holder. The nominal spread and the Z-spread are usually different but if the term structure is flat, they are the same. Hence, A could be true and is absolutely true if the term structure is flat.