CFA Institute CFA-Level-II Exam - Topic 1 Question 95 Discussion

Mike Diffle has been asked to evaluate the bonds of Hardin, Inc. The specific issue Diffle is considering has an 8% annual coupon and matures in two years. The bonds are currently callable at 101, and beginning in six months, they are callable at par. Bratton Corp, a competitor of Hardin's, also has bonds outstanding which are identical to Hardin's except that they are not callable. Diffle believes that the AA rating of both bonds is an accurate reflection of their credit risk. Diffle is wondering if the Bratton bonds might be a better investment than the Hardin bonds. Assume that the following 1-year interest rate tree is used to value bonds with a maturity of up to three years (this tree assumes interest rate volatility of 10%).

Also, assume that the appropriate spot rates for securities maturing in one, two, and three years are 7.25%, 7.5%, and 7.80%, respectively.

Diffle believes he should begin his analysis with the option-free Bratton bonds. He decides to consider two different approaches to valuing the Bratton Bonds---one that uses the current spot rate curve and another that uses the interest rate tree given above.

For the next step in his analysis, Diffle has decided to calculate the value of the Hardin bonds using the interest rate tree. His assumption is that the bond will be called ai any node of the tree where the calculated value exceeds the call price. Diffle summarizes the results of his bond valuation analysis in a memo to his supervisor, Luke Puldo. In this memo, Diffle makes the following statements:

Statement 1: The value of the option embedded in the Hardin bonds can be derived by simply subtracting the interest rate tree value of the Hardin bonds from the interest rate tree value of the Bratton bonds.

Statement 2: I am concerned that the 10% volatility assumption used to develop the interest rate tree might be too low. A higher volatility assumption would result in a lower value for the Hardin bonds.

After reviewing Diffle's analysis, Puldo notes that Diffle has not included any information on the option adjusted spread (OAS) for the Hardin bonds. Puldo suggests that Diffle should evaluate the OAS in order to get an idea of the liquidity risk of the Hardin bonds. Diffle counters that the OAS may not be very informative in this case, since he is uncertain as to the reliability of the interest rate volatility assumption.

To finish his analysis, Diffle would like to use his binomial model to evaluate the interest rate risk of both the Hardin bonds and the Bratton bonds. Diffle has shocked interest rates by 25 basis points throughout the interest rate tree he has been using to value the two bond issues. Using the new rates, Diffle has calculated values for the bonds assuming a 25-basis-point increase or decrease in rates. He plans to use these values as inputs into the following formulas for duration and convexity:

Indicate whether the statements made by Diffle in his memo regarding the value of the embedded option and the effect of the volatility assumption are correct.