CFA Level 1 - Fixed Income: Structured Securities Session 15

CFA Level 1 - Fixed Income: Structured Securities Session 15 - Reading 59 Valuing Mortgage-Backed and Asset-Backed Securities - LOS i (Notes, Practice Questions, Sample Questions) 1. The cash flows from mortgage-backed and some asset-backed securities are: A) interest rate path dependent. B) virtually free of prepayment risk. C) interest rate path independent. {Explanation}: The cash flows from mortgage-backed and some asset-backed securities are interest-rate path dependent 2. For a bond with an embedded option where the cash flows are not interest rate path dependent, which of the following valuation approaches should be used? A) The zero-volatility spread approach with the binomial model. B) The option-adjusted spread approach with the binomial model. C) The option-adjusted spread approach with the Monte Carlo simulation model. {Explanation}: The OAS method recognizes that cash flow changes accompany interest rate changes. Thus, it is suitable to use OAS analysis with ABSs that have a prepayment option that is frequently exercised, and if the cash flows are independent of the interest rate path, OAS should be computed with the binomial model 3. With the zero volatility spread (Z-spread) approach the value of an asset-backed security (ABS) is the present value of cash flows discounted at the spot rates plus the Z-spread. This means the Z-spread technique does not incorporate prepayments and thus would be appropriate to value: A) high quality home equity loans. B) auto loans or credit card loans. C) auto loans or high quality home equity loans. {Explanation}: The Z-spread would be appropriate for valuing auto or credit card backed securities, because neither are likely to refinance 4. When should an asset-backed security (ABS) be valued using the option-adjusted spread (OAS) approach? A) To value ABS that do not have a prepayment option. B) To value ABS that have a prepayment option. C) For agency ABS. {Explanation}: The OAS method recognizes that cash flow changes accompany interest rate changes. Thus, it is suitable to use OAS analysis with ABSs that have a prepayment option that is frequently exercised, e.g., high quality home equity loans 5. When is it best for an asset-backed security (ABS) to be valued using the zero-volatility spread approach? A) To value ABS that have a prepayment option. B) To value ABS that do not have a prepayment option. C) For agency ABS. {Explanation}: With the zero-spread method, the value of an ABS is the present value of its cash flows discounted at the spot rates plus the zero-volatility spread. The Z-spread technique does not incorporate prepayments. Thus, it should only be used for ABSs for which the borrower either has no option to prepay, or is unlikely to 6. For a bond with an embedded option where the cash flow is interest rate path dependent, which of the following valuation approaches should be used? A) The nominal spread approach with the Monte Carlo simulation model. B) The option-adjusted spread approach with the Monte Carlo simulation model. C) The option-adjusted spread approach with the binomial model. {Explanation}: The OAS method recognizes that cash flow changes accompany interest rate changes. Thus, it is suitable to use OAS analysis with ABSs that have a prepayment option that is frequently exercised, and, if the cash flows are dependent upon the interest rate path, OAS should be computed with the Monte Carlo simulation model 7. The nominal spread is the spread between the cash flow yield and the yield on a Treasury security with the same maturity as the average life of the mortgage-backed security (MBS) or asset-backed security (ABS) under analysis. For MBS and ABS the nominal spread: A) has nothing to do with prepayment risk. B) assumes no prepayment risk. C) masks the fact that a portion of the spread is compensation for accepting prepayment risk. {Explanation}: For MBS and ABS, the nominal spread masks the fact that a portion of the spread is compensation for accepting prepayment risk. 8. For a bond with an embedded option, if cash flows are independent of past interest rates, or not path dependent the: A) Z-spread should be used with the binomial model. B) option adjusted spread (OAS) should be used with the binomial model. C) option adjusted spread (OAS) should be used with the Monte Carlo simulation model. {Explanation}: If cash flows are independent of past interest rates, or not path dependent, the OAS should be used with the binomial model