CFA Level 1: Effect of Increased Interest Rate Volatility on OAS

Effect of Increased Interest Rate Volatility on OAS

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Question

Charlotte Villa, CFA, is a portfolio manager analyzing two securities. The 10-year bonds of Zehmer Corp. are callable beginning in two years. The 10-year bonds of Cavalier Inc. are not callable, but have a floating coupon that adjusts annually based on a margin above comparable maturity U.S. Treasury issues with no limits on the rate adjustment. Both bond issues are rated AA. Villa uses a computer model to value individual bonds based on their zero-volatility spread and/or option- adjusted spread (OAS). She decided to increase the interest rate volatility assumption in her model without changing any of the other model inputs. Identify how this change in assumption will affect the OAS for each bond.

Answers

Explanations

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A. B. C.

C

When analyzing bonds, the option-adjusted spread (OAS) is a measure that incorporates the embedded options in a bond, such as call provisions or floating-rate features. It represents the spread over the risk-free interest rate that investors demand for holding a bond, considering the additional risks associated with the embedded options.

In this scenario, Charlotte Villa, CFA, is analyzing two securities: Zehmer Corp. bonds and Cavalier Inc. bonds. Zehmer Corp. bonds are callable, meaning the issuer has the option to redeem them before maturity, starting in two years. Cavalier Inc. bonds, on the other hand, are not callable but have a floating coupon that adjusts annually based on a margin above comparable U.S. Treasury issues.

Villa wants to assess the impact of changing the interest rate volatility assumption in her computer model, while keeping all other model inputs unchanged. When the interest rate volatility assumption increases, it implies that there is a higher expectation of interest rate fluctuations in the future. Let's consider the effects of this change on the OAS for each bond:

  1. Zehmer Corp. bonds (callable): Increasing interest rate volatility tends to increase the value of the embedded call option. A higher level of interest rate volatility increases the probability that interest rates will move in a way that makes it advantageous for the issuer to call the bonds. Therefore, the value of the call option increases, and the OAS decreases. Consequently, the correct answer is that the OAS for Zehmer Corp. bonds will decrease (Choice C).

  2. Cavalier Inc. bonds (floating rate): Increasing interest rate volatility does not directly affect the value of the floating-rate feature since the coupon adjusts periodically based on prevailing market rates. The OAS for a floating-rate bond is primarily driven by credit risk and liquidity risk rather than interest rate volatility. Therefore, the change in interest rate volatility assumption should have no impact on the OAS for Cavalier Inc. bonds. Hence, the OAS for the Cavalier bond will remain unchanged (Choice C).

In summary, the correct answer is Choice C: The OAS for the Zehmer bond will decrease, but the OAS for the Cavalier bond will be unchanged.

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