Skip to content

FRM Part II · FRM Exam Part II · Arbitrage Pricing with Term Structure Models

A risk analyst at a bond fund values a callable corporate bond using an interest rate tree calibrated to the Treasury curve. The model price at zero spread is 101.20, while the bond trades at 98.70. Which statement best describes the option-adjusted spread (OAS) for this bond?

OAS is the constant spread added to every rate in the calibrated interest rate tree so that the option-inclusive model price equals the market price. It adjusts for the embedded call, unlike the yield-to-maturity spread or Z-spread, which ignore the option's effect on cash flows.

  1. AThe constant spread added to all tree rates so that the model price equals the market price of 98.70Correct
  2. BThe difference between the bond's yield to maturity and the yield on a Treasury of equal maturity
  3. CThe spread over the Treasury spot curve that equates discounted promised cash flows to price, ignoring the call option
  4. DThe price difference of 2.50 between the model price and the market price, expressed in basis points

Explanation

OAS is the constant spread added to the short rates at every node of the calibrated tree such that the model value, including the embedded option, equals the market price. Because the model price (101.20) exceeds market (98.70), the OAS is positive. The Z-spread option (ignoring the call) is the cash flow spread, not OAS.

Did you get it right without looking?

One question tells you little. A timed set on Arbitrage Pricing with Term Structure Models shows your real accuracy, how long you take and where you lose marks.

Practise Arbitrage Pricing with Term Structure ModelsFree diagnostic mock

More Arbitrage Pricing with Term Structure Models questions