Bond A has an embedded option, a nominal yield spread to Treasuries of 1.6%, a zero-volatility spread of 1.4%, and an option adjusted spread of 1.2%. Bond B is identical to Bond A except that it does not have the embedded options, has a nominal yield spread to Treasuries of 1.4%, a zero volatility spread of 1.3% and an option adjusted spread of 1.3%. What is the most likely option embedded in Bond A (call or put) and which Bond is the better value ? Schewsser says Embedded option = Put, Better Value = Bond B. I say, embedded option = Call, as OAS < Z- Spread, investor must be compensated for call risk and will require more yield and hence z spreads on callable bonds Better Value = Bond B based solely on non-option characteristics. Any thoughts ? Clarity on this ?
we did this one awhile ago - use search cuz I’m too lazy
this is a put option because the prospective bondholder is willing to pay 20bps more for the option.
I still don’t get it after reading through the post from December, searched Fixed Income OAS in level 1 forum. If I want to buy a bond w/ a put option, I’m willing to pay more (price up, yield down) compared to an option free bond. Wont my spread be less ?
Help me to understand…From Schweser Book 5 Page 126 #9 “The Z-spread - OAS = option cost in percent For callable bonds: Z-spread > OAS and option cost > 0 For putable bonds: Z-spread < OAS and option cost < 0” From the problem above, Bond A Z Spread, 1.4 > OAS 1.2. Option cost is .2. How is this an embedded put based on Schweser explanation quoted above.
it should be call option for bond A. Z- OAS >0 1.4 - 1.2 = .2>0 it should be callable. nominal spread is greater for Bond A means that yield will be more so price will be less. bond b ll be cheaper. Any thoughts??
are you referring to schweser notes book5, P 160, Q10. the answer B at P163 is an erro. should be B. pls check schweser website.
sorry, the right answer is D
Hey guys, the answer in in the simple put-call parity. Look at the formula. Cheers
Annexguy, Thanks… I’m still confused on why Bond B is ‘better value’ Bond A appears to be cheaper based on the nominal spread (higher yield)
"Bond A has an embedded option, a nominal yield spread to Treasuries of 1.6%, a zero-volatility spread of 1.4%, and an option adjusted spread of 1.2%. " So the bond would trade at a smaller spread if it didnt have embedded options (that’s what OAS means). The nominal spread here is not important because you compare the OAS to the z-spread. That means for example that I might be willing to pay 96 for the bond as is, but if they took the options off I would be willing to pay 98. That means I don’t like those options which means they accrue to the issuer. That means they are call options. "Bond B is identical to Bond A except that it does not have the embedded options, has a nominal yield spread to Treasuries of 1.4%, a zero volatility spread of 1.3% and an option adjusted spread of 1.3%. What is the most likely option embedded in Bond A (call or put) and which Bond is the better value ? " Again, we don’t care much about the nominal yield because we are compating this to Bond A. If Bond B is identical except it has no embedded option, it should trade at Bond A’s OAS = Bond B z-spread. However, Bond B z-spread = 1.3% and Bond A OAS = 1.2% (which above I said gave it a price of 98). That means that Bond B is trading at a higher spread which means it is a cheaper bond say, 97. That means that Bond B is a better value because I’m getting the same thing for less money.
got it…finally. thanks