The _ true _ OAS _ is not affected _ by a change in the volatility of interest rates. The _ calculated _ OAS _ is affected _ by a change in the assumption of the volatility of interest rates.
What you wrote is correct.
Iām certain S2000 is correct, but for exam day, what are peopleās thoughts?
Based on the excerpts people have posted, there is no mention of actual vs calculated OAS. Is this correct?
If a question comes up on the exam that asks about the effects of volatility on OAS, do we agree that we should go with the below:
There is an inverse relationship.
Higher Interest Rate Volatility decreases OAS
Lower Interest Rate Volatility increases OAS
I donāt understand why Z-spread would change with volatility. Isnāt Z-spread assuming zero volatility.
Take the basic equation:
OAS = Z-spread - Option Cost
To s2000magicianās point above, everything is affected, itās just a matter of what variables you change.
so, if you assume price is fixed, and change your vol assumption, OAS changes and Z-spread stays the same (Z-spread doesnāt change because you havenāt changed the price of the security)
if you assume price adjusts with vol (which is what really happens in the market), then OAS stays the same and z-spread changes (put differently, you require the same OAS despite the vol change so when you use the same OAS to discount back you get a different price)
This is why the reading states "For a given bond price"
Yes, for a given bond price (stupid as that is):
- An increase in the assumed volatility of interest rates will increase the value of call and put options, decreasing the OAS on callable bonds and increasing the OAS on putable bonds
- A decrease in the assumed volatility of interest rates will decrease the value of call and put options, increasing the OAS on callable bonds and decreasing the OAS on putable bonds
I understand how an increase in volatility of rates increases the option cost, decreasing the OAS on a callable bond. But how does an increase in volatility of rates increase the OAS on a puttable bond? Can someone please explain this looking at OAS = z-spread - option cost
Option cost is negative for a putable bond. Higher interest rate volatility makes the cost negativer, and subtracting that from the Z-spread makes the OAS positiver.
Nice, got it thanks.
So from the perspective of the bond holder the put option cost is negative. But what about from the perspective of the bond issuer, or do we not consider the issuer since they do not hold the put?
Theyāve sold the put to the bond holder, so they borrow at a lower effective rate that would relative to a callable or option free bond.
What i understand is that OAS spread is used as a pricing method to know if a callable/puttable bond is correctly priced compared to the market prices. In order to manually price your embedded option bond, it is necessary to make some assumptions such as the volatility.
For a callable bond, if you increase your implicit volatility, then the implicit OAS in your bond decreases to get the same market price. For a puttable bond, if you increase your implicit volatility, then the implicit OAS in your bond increases to get the same market price. In both case, the Z-spread keep stable and it is logical as you find the market price with every assumptions 
But if you purchase an embedded option bond, the volatility has nothing to do with the OAS spread.
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Hi S2000magician,
Thanks for the insight - Iād never seen it from this perspective before.
Are you saying that OAS would stay the same because we can reasonably assume that a change in the interest rate volatility would not affect, by itself, the perceived credit/liquidity risk of a bond with an embedded option (as far as I understand, OAS is calculated to separate credit/liquidity risk from option risk within the Z-spread)? Thus, a change in interest rate volatility would only affect the value of the option, e.g. a call option would increase in value for higher interest rate volatilities, meaning that the Z-spread would also increase for OAS to be constant (Z = OAS + call price), ultimately leading to a decrease in the price of a callable bond.
Iām not saying that the credit risk or liquidity risk will change when interest rate volatility changes. Iām saying that the value of any embedded option will change: as interest rate volatility increases, the value of call options and put options increase. If the market prices these bonds accurately, the price of the bond will change by exactly the amount of the change in the option value, so the OAS will stay the same.
Note that the market probably wonāt value them accurately. And that, even if they did, we cannot see all of the assumptions that the market employs to arrive at a value.
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sorry Iām jumping on this, but I donāt want to create a new thread. I am a bit confused after reading all this.
Does the volatility of the option affect the OAS?
For instance, the OAS of a callable bond is = Z spread - optionality cost.
So if the volatility of the underlying goes up, it means the option will have value, which means that OAS will go down. Am I correct? So the answer to my question is YES, volatility of the option does affect the OAS
No.
If the volatility of interest rates changes, the price of the callable bond will change, so its z-spread will change as well. If everything is priced correctly, the OAS should not change, because the OAS is the spread for the underlying, option-free bond.