Hi, is this answer wrong? How does OAS exclude default risk? I thought OAS only exclude effects of options on the bond issue in question?
I meant the 2012 CFA curriculum
I remember this utter stupidity from last year… Level 2 taught us that it did include default risk, and is pretty much as you described, just a means of removing the spread attributable to the option. However Level 3 wants you to think it does not include default risk. I have no answer as to why this is, last year I never got to the bottom of the inconsistency myself. In the end, just assume for exam purposes you need to say it does not include default risk and move on.
OAS does not include any valuation for default risk. I don’t think Lvl 2 ever said that it did . All option payoff models assume that when it comes time to exercise , the option writer will be solvent and will deliver the contract.The value of the contract depends only on prices and volatility in the market . OAS is not some magical process that will account for default risk , because that would be quite specific to the issuer . Of course options on credit defaults also exist but those are a different type of contract( being more tied to the issuer than to the goods being insured ) . OAS embedded in mortgages does not depends only on prepayment models which are issuer un-specific
Credit spread (compensating for credit risk) and credit spread includes defalut spread (compensating for default risk). That is, default risk is a kind of credit risk. So OAS shall include defalut spread (defalut risk is accounted). Am I wrong ?
This is a classic example of why the text is just fucking weak. Some things are simply not explained beyond what’s stated. It’s like, forget the reality you learned in L2 because in the middle of page 76 it says quite plainly, “Given the exclusion of default risk in OAS option-valuation models…” But for a better answer (and to assure yourself that you haven’t gone insane) read here: http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91307062