The correct answer is C.

The cash flows for securities that are not priced according to the model are discounted at the short-term rate plus the OAS. The Option-Adjusted Spread (OAS) is a measure used to compare the yield of a security that has an embedded option with the yield of a benchmark security. The OAS of a security is a constant spread that needs to be added to the benchmark yield curve to discount a security’s payments to match its market price. OAS is hence a tool used by investors to compare two income-producing securities when one of them has embedded options. Therefore, when securities are not priced according to the model, their relevant cash flows are discounted at the short-term rate plus the OAS. This is because the OAS represents the additional yield an investor requires for assuming the risk that the embedded option will be exercised.

Choice A is incorrect. The short-term rate alone is not used to discount the cash flows of securities that are not priced in line with the model. This is because it does not take into account the option-adjusted spread (OAS), which reflects the difference between the security's yield and a benchmark yield, adjusted for any embedded options.

Choice B is incorrect. The long-term rate alone also cannot be used to discount these cash flows as it fails to consider OAS, which plays a crucial role in pricing such securities.

Choice D is incorrect. The short-term rate minus the OAS would result in an underestimation of risk and therefore an overestimation of value for securities that are not priced according to model predictions. This approach would fail to adequately compensate investors for taking on additional risk associated with these types of securities.

Things to Remember

• Option-Adjusted Spread (OAS) is a measure used to compare the yield of a security with an embedded option to a benchmark security.
• OAS is a constant spread that needs to be added to the benchmark yield curve to discount a security’s payments to match its market price.
• Investors use OAS to compare two income-producing securities when one of them has embedded options.
• Discounting cash flows at the short-term rate plus the OAS is necessary for securities.