CFA Practice Question

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CFA Practice Question

Which of the following statements is (are) true with respect to the effects embedded options would have on the price and the yield of the underlying bond?

I. The yield on putable bonds will always be lower than the yield on an otherwise identical option free bond.
II. The greater the interest rate volatility assumed, the lower will be the price of an option free bond.
III. Option adjusted spread, in general, is simply the compensation to an investor for bearing credit and liquidity risk.
IV. For an option free bond, the zero volatility (or static) spread will be higher than its corresponding option adjusted spread.
A. I, II and IV
B. II and IV
C. I and III
Explanation: I is true because the price of putable bonds are always more expensive than non-putable bonds (this is because the put in the bond would be an attractive feature to the investor, i.e., He has to pay for it). Consequently, this higher price for a putable bond will translate into a lower yield.

II is incorrect because interest rate volatility only has an impact on the embedded options. In other words, as the interest rate volatility is assumed to increase, both the call and the put values will increase. However, in the absence of these options, the bond price will not be affected.

III is true because option adjusted spread is the spread that is left once the adverse effects that a call option will have on the investor's return, have been stripped away.

IV is incorrect because for an option free bond, the zero volatility (or static) spread and its corresponding option adjusted spread will be equal. The only difference between the two measures is the incremental yield due to call risk. Hence, in the absence of this call risk, the two measures of spread will produce the same result.

User Contributed Comments 1

User Comment
mghebrey that sums it all up!
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