CFA Practice Question

There are 490 practice questions for this study session.

CFA Practice Question

The yield curve is flat. A bond with an OAS of 40 basis points has a G spread of 175 basis points. Which of the following is true?

A. The 175 basis points are all uncompensated risk to the investor.
B. The 40 basis points are uncompensated risk to the investor.
C. There may be 135 basis points that are uncompensated risk to the investor.
D. There may be 135 basis points that are uncompensated risk to the borrower.
Correct Answer: C

The difference between the G spread and the OAS is the value of the option. This is uncompensated risk to the investor. 175 - 40 = 135

User Contributed Comments 13

User Comment
george2006 since the option cost is positive meaning that this is a callable bond. Because the flat yield curve, z-spread = nominal spread. Isn't investor compensated by the higher spread 135bp than the OAS? Why calling it uncompensated?
katybo 135bp is the value of the option. The compensation part is the OAS, because it compensates for the inherent risks excluding option risk.
mishis I don't get it!! why uncompensated risk if he is earning 175 bp nominal spread which includes value of embedded option, anyone? 135 is cost, so it is not part of the spread?
jack1jack The OAS compensates for liquidity and credit risks. The other 135 bp may be used to compensate option risk. But if there is no option in the bond, the entire 135 bp is extra compensation. One needs to pay attention to the phrase "There may be".
rhardin I'm sorry, I still don't understand this question. The "may be" part is confusing me. Can someone please further elaborate? Thank you!
Kashi2010 I dont understand the use of 'uncompensated'.
OAS+40 = credit/liquidity/reinvestment (etc) risk
residual+135bp = optionality risk (i.e. option premium).

As such it seems to follow that the investor is compensated to the tune of 40bp for credit/liquidity/reinvestment risk, and 135bp for the risk that the issuer will call the bond. Hence all risks carry spread compensation....??
pbielstein I think that the 135 bp of 'uncompensated' risk refers to the fact that the investor who sees the bond trading at a (nominal) spread of 175 bp might think that this is compensation for the credit and liquidity risk whereas, in fact, only 40 bp are compensation for those two factors and the major part (135 bp) just compensates for the embedded option.
joywind can also think it in this way... investors buy the bond paying the price with a high spread (175bp very high premium) and only 40bp is the premium should be paid for the equivalent option-free bond, then, all the rest 135bp spread is the premium paid for the option, whose payoff can never be known until expiration. In other words, this part of the premium you paid but not compensated?
rana1970 Remember all friends,
All spread measures (nom, Z & OAS) are added to treasury yield for compensating certain risks in the security. Here 135 bps are not explaining any risk, so uncompensated which actually benefits the investors. He'll get lower price.
Now think why 135 bps is being added, when it is not really needed? It is the option cost ZS=OAS+option cost;

Now , when yield curve is flat, should there be any option cost? May be not?
johntan1979 Yes, Queen Rania :)
CJPerugini The answer should be B. OAS is the spread to the government spot rate curve that the bond would have if it were option free, AKA uncompensated risk.
CJPerugini Disregard. Thought the question gave us the Z-spread. C is correct.
CJPerugini Fugit I still think it's B. I'm done.
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