The bonds of Grinder Corp. trade at a nominal spread of 150 basis points (bp) above comparable maturity U.S. Treasury securities. The option adjusted spread
(OAS) on the Grinder Corp. bonds is 75 bp. Using this information, and assuming that the Treasury yield curve is flat, which of the following statements is most likely to be true?
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A. B. C.Explanation
To answer this question, let's break down the information provided:
Now, let's understand what these terms mean and analyze each statement to determine which one is most likely to be true.
Nominal Spread: The nominal spread is the difference between the yield of a bond and the yield of a risk-free benchmark, in this case, comparable maturity U.S. Treasury securities. It represents the compensation investors demand for taking on the additional credit risk associated with Grinder Corp. bonds. In this case, the nominal spread is 150 basis points (bp) above the Treasury securities.
Option-Adjusted Spread (OAS): The option-adjusted spread takes into account the embedded options in a bond, such as call or put options. It measures the spread above the risk-free rate that compensates investors for all risks, including credit risk and any potential impact of the embedded options. In this case, the OAS is 75 basis points (bp).
Flat Treasury Yield Curve: A flat yield curve means that the yields of Treasury securities are the same across all maturities.
Now, let's evaluate each statement:
A. The zero-volatility spread should be 75 bp. The zero-volatility spread (Z-spread) is the spread that, when added to each spot rate on the Treasury yield curve, makes the present value of the bond's cash flows equal to its market price. The Z-spread incorporates only the credit risk component and assumes zero volatility in interest rates. However, the OAS accounts for both credit risk and the potential impact of embedded options. Since the OAS is 75 bp, it is likely to be lower than the Z-spread, so this statement is unlikely to be true.
B. The zero-volatility spread for these bonds is 225 bp. Similar to the explanation for statement A, the Z-spread is expected to be higher than the OAS. If the OAS is 75 bp, it is unlikely that the Z-spread would be 225 bp. Therefore, this statement is also unlikely to be true.
C. The option cost component of these bonds should be 75 bp. This statement is the most likely to be true. The OAS of 75 bp represents the additional spread above the risk-free rate that compensates investors for all risks, including credit risk and the impact of embedded options. Therefore, the option cost component of these bonds is likely to be 75 bp.
In summary, the most likely statement to be true is: C. The option cost component of these bonds should be 75 bp.