questions of CFA-I (fixed income)

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9.The effects of a decrease in interest rate (yield) volatility on the market yield of
a debt security with a prepayment option and on a debt security with a put
option are most likely a(n):

Prepayment option Put option
A. Increase Increase
B. Increase Decrease
C. Decrease Increase
D. Decrease Decrease
[C]

Answer
A decrease in yield volatiliry will decrease the values of embedded options. The security
holder is short the prepaymen t option. The decrease in the val ue of the prepayment
option increases the value of the security, and the required .yield will decrease. The
securiry holder is long the put option so the value of a putable bond will decrease with
a decrease in yield volatility and the required yield will increase.

10. Bond A has an embedded option, a nominal yield spread to Treasuries of 1.6%,
a zero-volatility spread of 1.4%, and an option-adjusted spread of 1.2%. Bond
B is identical to Bond A except that it does not have the embedded option, has
a nominal yield spread [Q Treasuries of 1.4%, a zero-volatility spread of 1.3%
and an option-adjusted spread of 1.3%. The most likely option embedded in
Bond A, and the bond that is the bener value, are:

Embedded option Better value
A. Put Bond A
B. Put Bond B
C. Call Bond A
D. Call Bond B

Since the GAS is less than the Z-spread for Bond A, the effecr of the embedded option
is to dectease the required yield, so it must be a put option and not a call option. The
OAS is the spread after taking our the effect of the embedded option. Since the OAS is
higher for Bond B, it represents the berter value after adjusting for the value of the put
in Bond A.