FRM Part II · FRM Exam Part II · Arbitrage Pricing with Term Structure Models
A callable bond has a Z-spread of 180 bps over the spot curve. The embedded call option, valued using the term structure model, is worth 45 bps per year in spread terms. Assuming the option cost is measured consistently, what is the approximate OAS?
The OAS is about 135 bps. The Z-spread of 180 bps includes compensation for the issuer's call option worth 45 bps, so subtracting the option cost leaves the pure credit and liquidity spread. Adding it instead would be a sign error.
- A225 bps
- B135 bpsCorrect
- C180 bps
- D45 bps
Explanation
Z-spread = OAS + option cost, so OAS = 180 − 45 = 135 bps. The investor is short the call to the issuer, so part of the apparent spread compensates for the call. Adding the option cost (225) is the sign error.
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