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 a putable bond will always be lower than the yield on an otherwise identical option-free bond.
II. The greater the interest rate volatility assumed, the lower 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.

Explanation: I is true. The price of putable bonds is always higher than that of non-putable bonds (because the put in the bond is an attractive feature to an investor it will command a higher price). The putable bond’s higher price will translate into a lower yield.

II is incorrect. 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. Option-adjusted spread is the spread that is left once the adverse effects that a call option will have on an investor's return, have been stripped away.

IV is incorrect. 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.