The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

QUESTIONS

1. The value of a Treasury security should be based on discounting each cash flow using the corresponding Treasury spot rate. Explain why this is true.

2.

a. What is the typical relationship between credit spreads and term to maturity?

b. How does this relationship change as credit ratings decline?

3. Explain what is meant by the nominal spread and the zero volatility spread? How are they computed?

4. Answer the following questions about valuing bonds with embedded options.

a. Explain how an increase in expected interest rate volatility can decrease the value of a callable bond?

b. What is the option-adjusted spread (OAS)?

c. Explain the impact of greater expected interest rate volatility on the option-adjusted spread of a security.

5. Answer the following questions about valuing bonds with embedded options using a binomial interest rate tree:

a. Why is the procedure for valuing a bond with an embedded option called “backward induction”?

b. Why is the value produced by a binomial model referred to as an “arbitrage-free” value?

6. Suppose the following information is available from the Treasury spot curve:

Three-year spot rate = 3.410% Four-year spot rate = 3.854% Answer the following questions.

a. What is the implied forward rate on a one-year zero coupon Treasury three years from now quoted on a bond-equivalent basis?

b. Antti Illmanen states, “Whenever the spot rate curve is upward sloping, the forwards imply rising rates. That is, rising rates are needed to offset ...