OAS compensate for option risk right? So does it mean that callable and putalbe bonds have the same OAS( which is positive)? When will OAS be negative?
NEgative OAS means put option. Positive means Call option
Sorry: _ you’re both wrong _.
OAS removes the option: it’s the spread that compensates the bondholder for everything other than the option risk.
The OAS is positive for risky bonds. It’s less than the Z-spread for callable bonds and greater than the Z-spread for puttable bonds.
The _ option value _ is positive for callables and negative for puttables , _ not the OAS _.
Be careful!
Thanks Magician to point it out.
Does the perspective you take on these matter?
For example you’ve got a bond with a OAS 130, yet a comparable bonds OAS is 150 (everything else identical).
To me, this would mean that the 130 is undervalued? You’re getting compensated 20 bp’s more with the 150? I know the answer is the opposite, but I can’t figure out why?
Thanks!
If the OAS is 130bp instead of 150bp you’re earning a lower return than you should: the bond’s overpriced.
Higher yield = higher discount rate = lower price.
Got it. So I guess another assumption you’re making is that the price of the two bonds is the same.
I know obvious statement, but not so obvious in the context.
I was confused on this for a while. Just remember, OAS is a SPREAD measure pegged off of something else.
So if you are pegging the OAS off of something that yields 1%, and in your example there are two comparable bonds that have OAS’s of +1.3% and +1.5%, that would mean you are OVERPAYING for the +1.3% because you aren’t getting as much yield as you should be.
Not sure if that helps, but its how I think about it…and I’ve been able to answer every OAS question correctly.
prices aren’t the same, thats what makes the OAS’s different in your example.
No. If bond A and bond B have essentially identical risks, they should have nearly identical OASs. If bond A pays a 4.5% coupon and bond B pays a 5.2% coupon, they shouldn’t have the same price. The two ideas are independent.
I think i’m missing a lot of bits and pieces to OAS…
OAS is the additional spread/yield for having an embedded option?
Higher OAS is better because it means you are getting a higher yield?
Also applying it to a binomial tree you have to shift the curve instead of just adding the spread to all the spots? (if that’s correct I don’t really know what that means)
No.
OAS _ removes _ the effect of the option.
Yes.
Shifting the curve and adding the same spread to each of the spots mean the same thing.
Ah i see… so OAS is like your “net” spread ?
Yes, so you can compare it to the Z-spread of a comparable option-free bond which is the required OAS and make relative valuation.
I got this wrong on the mock. But glad I did, because forced me to learn those spreads better.
Z Spread - OAS = Cost of option.
OAS = Option removed spread, i.e. Spread EXCLUDING the option.
For identical bonds, you want to pay as little as possible for the option. You want to choose the bond with the higher OAS.
Hi S2000,
I just did a question with the explnations below to OAS. It is from Kaplan. Just got lost in OAS. They mention OAS will be positve for callable bond but on your post from 2013, you mention OAS is positive for Risky bond. Does it mean, it is always POSTIVE fro putabble bond? Thank you!
The OAS is a constant spread added to every interest rate in the tree so that the model price of the bond is equal to the market price of the bond. In this case, using the interest rate lattice, the model price of the callable bond is greater than the market price. Hence, a positive spread must be added to every interest rate in the lattice. When a constant spread is added to all the rates such that the model price is equal to the market price, you have found the OAS . The OAS will be positive for the callable bond.
Unless something really, really weird (i.e., completely wrong) is going on, the OAS (versus a Treasury or other risk-free interest rate tree) should be positive for a risky bond, whether it’s straight, callable, putable, prepayable, convertible, whateverable.
Remember that the OAS removes the value of any embedded options, so you’re left with a spread for a straight, risky bond. Unless something is really, really weird (i.e., completely wrong), a risky bond should have a higher yield than a risk-free bond of the same maturity: as a bondholder, you demand extra return to take on extra risk.
Hi S2000magician,
Thanks for the reply! Actually I just ran into a similar one as I am going through my notes. I know I might compare apple to orange again. But would like your thoughts on.
I-Spread only reflects comenpesation for CREDIT and LIQUIDTY Risks. OAS = credit risk + liquidity risk. If these are both true, what is the relationship between OAS and I-Spread since they are reflecting the same type of risks?
Thanks in advance!