David Young, CFA, has decided to add some asset-backed securities (ABS) to his fixed-income portfolio. He has narrowed the choice to an automobile ABS and a fixed-rate home equity loan (second mortgage) ABS.
Automobile ABS are available at a pricing spread of 75 basis points over comparable maturity Treasuries, with a zero volatility spread of 67 basis points. Home equity loan ABS are available at a pricing spread of 85 basis points over comparable-maturity Treasuries, with an option-adjusted spread of 60 basis points.
a. Explain why the traditional yield spread is not an appropriate measure of yield advantage for ABS.
b. Describe the concepts of:
(1) Zero volatility spread
(2) Option-adjusted spread
c. Explain why option-adjusted spread is the appropriate measure of yield for a second mortgage ABS.