THIS BOOK EXPLAINS a traditional approach to solving for the option-adjusted spread of a bond: how an investor can identify the value inherent in the cash flows and embedded options relative to market reference levels. Underlying the method is the theory that a bond can be described as a portfolio of zero-coupon strips (the cash flows) and interest-rate options (the calls and/or puts). The incremental yield an investor receives on the bond above benchmark alternatives is a combination of interest premium and option premium. Through appropriate modeling techniques, one can discretely value the option components and thus clarify the incremental spread paid on the cash flows versus benchmark.
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