P2.T5.114. MBS Spreads: nominal versus Z-spread versus option-adjusted (OAS)

Discussion in 'Today's Daily Questions' started by David Harper CFA FRM CIPM, Feb 15, 2012.

  1. AIMs: Discuss limitations of the nominal spread, Z-spread, OAS, and total return measures.

    Questions:

    114.1. Assume the 1.5 year Treasury yield curve is steep: 1.0% at 0.5 years, 2.0% at 1.0 year, and 3.0% at 1.5 years. A speculative corporate $100 par bond has 1.5 years to maturity, pays a semi-annual coupon rate of 9.0% per annum, and has a current price of $91.00. What is the bond's nominal spread?

    a. 12.98%
    b. 13.00%
    c. 13.02%
    d. 13.05%

    114.2. Assume the 1.5 year Treasury yield curve is steep: 1.0% at 0.5 years, 2.0% at 1.0 year, and 3.0% at 1.5 years. A speculative corporate $100 par bond has 1.5 years to maturity, pays a semi-annual coupon rate of 9.0% per annum, and has a current price of $91.00. What is the bond's Z-spread? (please note: 1. As this solution is iterative, you need to find it among the answers; 2. For the same reason, this question is more difficult than you could expect on the exam)

    a. 12.98%
    b. 13.00%
    c. 13.02%
    d. 13.05%

    114.3. Your colleague John is studying for the FRM Part 2 and he makes the following statements about the valuation of mortgage-backed securities (MBS):

    I. A 9.00% bond-equivalent yield equates to a 9.17% mortgage yield
    II. The nominal spread is the difference between the cash flow yield (aka, mortgage yield) and the yield on a Treasury security with the same maturity as the average life of the MBS
    III. The z-spread (aka, static spread) is the spread that will make the present value of the cash flows from the MBS equal to the price of the MBS when discounted at the Treasury spot rate plus the spread
    IV. Unlike both the nominal and the z-spread, which do no recognize prepayment risk, the option-adjusted spread (OAS) does recognize prepayments on the MBS

    Which is true about John's statements?

    a. None are correct, John needs to hit the books!
    b. Only II. and III. are correct, John might want to study this topic more
    c. Only I. and IV. are correct, John might want to study this topic more
    d. All four statements are correct, John sure knows his Fabozzi!

    Answers:

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