The question is comparing 2 bonds. Bond A has embedded option. A nominal sperad to treasuries of 1.6%, Z-Spread of 1.4%, and OAS of 1.2%. Option B is option-free. Has a nomial spread of 1.4%, and a z-spread and OAS of both 1.3%. The question asks you to identify the option embedded in bond A and to select the bond with better value.
It is obvious that the option embedded is call option in Bond A because OAS is less than Z-Spread.
I chose the bond with better value as Bond B. Because I think Bond A has higher nominal spread than that of Bond B (1.6% versus 1.4%), which means bond A bears more risk comparing to treasury bond than bond B does. Also, Bond B has lower Z-Spread, which means when we are discounting the cash flow, the present value of Bond B will be higher than that of Bond A because B has a lower discount rate after taking into account the Z spread.
The answer is correct. Bond B has better value but its explaination in the back says Since the OAS is higher for Bond B, it represents the better value after adjusting for the value of the call in Bond A.
I just don’t see how a higher OAS equals to better valued bond. Doesn’t OAS take into account all the risks like credit risk, liquidity risk, etc. Higher spread means higher risk? And what does a bond with better value mean anyways? Does better value mean higher PV or what?
Thx in advance!