How to understand the OAS in spread duration section.
I noted the formula in this section, but I am confused whether this means spread or the dollar duration of OAS?
OAS=Z spread-option value
most likely it is dollar duration, right?
No. it’s the actual spread over treasuries with the value of the option removed.
Is this formula mean that : IE a bond with call option and currently priced at $85, par$100, assume the call option value is $5, then the OAS shoud be using $85-$5=$80 as price, and calculate the Z-spread?
pls advice,
many thanks!
Z spread would be the “constant” spread that added to each spot rate along the treasury 'ss curve rate will equal the calculated price to the market price.
So imagine that in order to calculate the market price of 85, when discounting each of the cash flows of the bond the z-spread will be that “constant spread” that you add to every discount rate used to discount those cash flows.
I think your OAS calculation is not right. You have to discount the embedded cost of the option from the “nominal spread” of the bond. You are just discounting the cost of the option to the price of the bond. OAS is based on spread not price.