Niblita75 Wrote: ------------------------------------------------------- > The option costs for each tranche are: > > 17 > 20 > 65 > > The option for tranche 3 is 3x more expensive than > tranche 2. Tranche 3’s OAS is only 2 bps higher > yet costs 45 bps more. Hang on, is it correct to assume that the option is the same for all 3 tranches? Maybe the options are different, and should therefore be priced differently. I think the duration is key here - tranch 3 has much higher duration (and therefore interest rate risk) yet costs about the same. So on a risk-adjusted basis it’s way more expensive than tranch 1 and 2.
deep2002 Wrote: ------------------------------------------------------- > the answer is A because of the duration effect. I > had fallen for the same trap and picked D. But I > do not understand why its A instead of D because I > always thought that you always wanted the highest > OAS. > > Can someone explain it in a little detail please. Post the answer you got from Schweser.
First calculate the option cost of each tranche: Tranche 1 option cost =85-68=17 basis points Tranche 2 option cost =91-71=20 basis points Tranche 3 option cost=136-73=63 basis points Tranche 3, despite its longer effective duration has a comparable OAS and a much higher option cost than Tranches 1 and 2. A risk-adverse investor would demand a higher OAS on Tranche 3 than on Tranches 1 and 2 because of its longer duration. Therefore, on a relative basis, Tranche 3 is relatively more expensive than Tranches 1 and 2.