Credit Risk Management Practice Exam

Which measure accounts for interest rate volatility and is used for bonds with embedded options?

1. Z-Spread

2. OAS

3. I-Spread

4. Yield Spread

The correct answer is: OAS

The measure that accounts for interest rate volatility and is specifically used for bonds with embedded options is the Option-Adjusted Spread (OAS). OAS quantifies the yield spread of a bond over a risk-free benchmark yield, adjusting for the value of any embedded options like call or put options. By factoring in interest rate volatility, OAS provides a more accurate assessment of the return investors can expect, considering that the presence of these options can significantly influence the bond's pricing and yield. In contrast, the Z-Spread is simply the constant spread that, when added to the yield curve, will equal the present value of the bond's cash flows but does not adjust for the embedded options. The I-Spread, on the other hand, refers to the difference between the yield of a corporate bond and the swap rate, which is not specifically designed to address the complexities introduced by embedded options. Yield Spread represents the difference in yields between two different bonds or asset classes but lacks the adjustments for volatility and options that OAS incorporates.