Which of the following statements is correct concerning the collateralized mortgage obligation (CMO) tranches shown in the following figure? tranche OAS Zspread effective duration 1 68 85 2.6 2 71 91 2.9 3 73 136 8.25 A. Tranches 2 and 3 are relatively less expensive than Tranche 1. B. Tranches 1 and 2 are relatively less expensive than Tranche 3. C. Tranches 1 and 3 are relatively less expensive than Tranche 2. D. Tranches 1, 2, and 3 are approximately the same value.
option cost = 17 OC = 20 OC = 63 B looks good to me?
B
B
B Relatively the same OAS, you’re getting the shaft with the effective duration on tranche 3.
i will go for B too
agree w above
thanks for you all. I originally think the cheapest is the tranche with the largest OAS.(tranche3) Now, I know the correct way is to find the lowest option cost.(thanche1)
The lowest option cost isn’t entirely correct. Look at the difference in duration. You have a lot more interest rate risk compared to the other two and you are not being compensated for that either.
Yep, the cfai has a couple good q’s on this you should check out.
sorry for bringing this post back in attention but my reasoning - and the Z Oas and nominal spread have never been my forte- is that you should not consider the option cost I thought that options are what they are-we should not analyze them since we don’t know what call price they have etc. The thing would be though that we know since you take out the option price, bonds with same credit and liquidity should price the same Now if we look the OAS spread are almost the same but duration - which is for me a measure of risk it’s much higher for the 3 bond. what do you guys think?
thats exactly it florinpop, the higher duration is a sign that it is a longer maturity term and therefore is exposed to greater risk. When valuing these you have to take into consideration both the OAS, option cost and effective duration and chose the best one.
the point was that I really dont think that the option value itself gives us any info is a option worth 40bp more expensive than one worth 20bp? could be either way cause it does not specify call price for example so the 40bp one could actually be cheaper if it allows calling the bond at a lower price or bonds can only be called at par??
No, I don’t think you can specify the option cost in that way. You can only do it for similar bonds and compare the two to see which is better knowing that they are both similar bonds except that one has a higher option cost than the other.