LOS 47.e Evaluate MBS using OAS spread analysis

CFA Level II Fixed Income
#1

I’m a little confused about the option cost component of this analysis.

In Schweser p290 of FI book it says

“Cheap securities will have high OAS relative to the required OAS and low option costs” (we want to buy these)

“Rich securities will have low OAS relative to the required OAS and high option costs” (we want to sell these)

I think I get the OAS part. We’re funding the MBS so we want the highest spread.

What I don’t get is the option cost component. I get that the option cost is equal to Z-Spread - OAS, but why does low option cost imply cheap security.

In the case of an MBS, we are funding/lending money by buying the MBS and the mortgage holders are the ones who have borrowed money through the MBS. By having the choice to repay early, they are the ones who own the option to repay (i.e. call the loan by giving back the money). So if they own this option, we have sold it to them effectively. So wouldn’t we want the option costs to be high since we are the option seller?

What’s wrong with my thinking?

#2

Everything else being equal, we would prefer selling a high-cost option to selling a low-cost option. Everything else is rarely equal, however.

If the option cost is high, the option is more likely to be exercised. (The issuer didn’t buy it for no reason.) If the option cost is low, the option is less likely to be exercised. (We didn’t sell it for cheap because we thought they’d be stupid and forget to exercise it.)

So, we’d like to get a high OAS on a bond we think won’t be called/prepaid: high OAS, low option cost.

#3

I need to mark it as well