This question is total BS…is the required spread is not provided in the item set, then they shouldn’t ask a question about it, correct? Sometimes I hate Schweser…thoughts? The benchmark securities used to create the tree are treasury securities, so the OAS for each callable corporate bond reflects additional credit risk and liquidity risk relative to the benchmark. The bonds are overvalued if their OAS are smaller than the required OAS and undervalued if their OAS are larger than the required OAS. The required OAS for both bonds is the Z-spread over treasuries on comparably-rated securities with no embedded options. That required spread is not provided in the vignette. The BB-rated issue is overvalued because its OAS is less than zero, which means it must be less than the required OAS. Therefore Evermore is correct in her analysis of the BB-rated issue. The AA-rated issue has a positive OAS relative to the treasury benchmark, but we don’t know the required OAS on similar bonds, so we can’t determine whether or not the AA-rated issue is over or undervalued based on the information given. Therefore Evermore is incorrect to conclude that the issue is undervalued. For Further Reference: Study Session 14, LOS 55.a SchweserNotes: Bk 5 p.85 CFA Program Curriculum: Vol. 5 p.268
dude - this is exactly the kind of questions you will be aksed in the real deal. If you want to close your eyes and think that nobody is watching you drink the milk, then you are perfectly fine with bitching about Schweser here. Make sure you got the concept underlying the question.
^exactly
Thanks. I do get the main point. Large OAS = undervalued, Small OAS = overvalued. But in this specific question, relative to what? I still hate Schweser sometimes…we have a love/hate relationship
We have 2 corporates which are rated AA and BB respectively and both are being compared to Treasury benchmarks.
okay, I think of OAS = Z spread - option cost…is there another way to think of it? I might be missing something. I DO know an investor prefers a high OAS vs. a low OAS.
the way i always think about is OAS is what the value of the bond would be with no option. But z-spread - option cost kind of says that too…
Exactly…OAS = The price of the bond, without the option. Or, the bond price adjusted for the option cost. I thought callable/putable bonds were only on corp. bonds (except MBS)…therefore…OAS = Z-spread - option cost. Z spreads are only associated with corp. bonds…
I encountered the same question on mock this year, it is Mock one question 34, can someone help me understand this?