As interest rates become more volatile, option-adjusted spreads on callable bonds whose prices are unchanged tend to: A. Increase B. Decrease C. Be the same D. Become Zero The correct Answer is B apparently. I put C. My argument is this. If OAS is the spread adjusted for embedded options how can interest rate volatility impact the OAS through its effect on the embedded call option in the bond. By definition should the answer not be C? Is the crux of the question that “whose price does not change”? - My guess is that because effectively (for a callable bond) OAS = Z spread - value of call option If the price doesn’t change, Z-spread will not change, thus the increase in the price of the call option (due to increase in volatility) must instead be offset by a fall in the OAS. But this seems unintuiative - because OAS removes the effect of the embedded option. Therefore OAS must be unaffected by changes in the value of the option?
it’s a stupid problem, very counter-intuitive.
I don’t know about that. Value of option of benefit to issuer increases, price constant => OAS decreases. More of the nominal spread is eaten up by the option value, so less of it is due to plain old credit (the OAS).
chrismaths Wrote: ------------------------------------------------------- > I don’t know about that. > > Value of option of benefit to issuer increases, > price constant => OAS decreases. > > More of the nominal spread is eaten up by the > option value, so less of it is due to plain old > credit (the OAS). There is no change in the underlying credit quality of the bond. Your (and their) answer is saying that the OAS has fallen purley due to a change in the value of the option - yet the OAS by definition should not be affected by the embedded option!
Edit: I realise my above reponse isn’t helping anything. In reality (i think?) the price of the bond would fall, thus the yield would rise to compensate the bondholder for the increased value of the call option to the issuer. I agree with maratikus that its a very poor question. Stipulating that the price doesn’t change just seems to me a like a stupid way to test people’s ability to memorise forumla’s from the book. Not a good strategy at the best of times, but this, in my opinion, is a really poor question which will only confuse candidates.
Z spread = OAS + option cost. I guess their logic is that is Z spread is constant and option cost increases, then OAS will decrease.
This is terrible pedagogy. “As interest rates become more volatile, option-adjusted spreads on callable bonds whose prices are unchanged” is not at all clear. Their prices can be unchanged but that says nothing about their spreads because we don’t know what happened to the price of risk-free bonds. Further even saying something like their yields remain unchanged doesn’t help because we care about the z-spread here. Mostly, everone should think that as vol increases, callable bonds decrease in price while OAS remains the same. This question is messing with that by saying if it’s not so what has happened. Very silly.