Remind me again about OAS. It’s the nominal spread after the option is adjusted out, right?
But in vol. 4, reading 24, page 76, in the section on spread analysis, it states, “Given the exclusion of default risk in OAS option-evaluation models, OAS valuation has seen only limited extension into higher-risk markets…”
What is meant by the statement, “exclusion of default risk in OAS option-evaluation models”?
OAS does not include default risk.
What’s included in the OAS if not default risk?
option risk?
From http://www.riskglossary.com/link/option_adjusted_spread.htm “If a bond has embedded options, its Option-adjusted spread (OAS) is the spread at which it presumably would be trading over a benchmark if it had no embedded optionality. More precisely, it is the instrument’s current spread over the benchmark minus that component of the spread that is attributable to the cost of the embedded options:”
You remove option value from the spread on the option embedded bond to get OAS. What remains in OAS is Credit risk and liquidity risk and other risks. Consequently, OAS is comparable with other option less bond spreads.
Correct, that’s right out of the L1 book. Credit risk includes default risk. So I’m trying to figure out this statement on page 76: “Given the exclusion of default risk in OAS option-evaluation models…” What is meant by “default risk from OAS option-evaluation models”? Further, look at question 26 on page 96. Why is the answer A (“OAS excludes default risk from its calculation…”)? It seems like the authors are making a distinction with junk bonds, but I cannot figure out why.
Moody, you are right. I remember reading this couple weeks ago. As I recollect, the author stressed on the fact that comparing corporate bonds and junk bonds on the basis of OAS is not appropriate due to the fact that junk bonds OAS include substantial default risk or credit risk in them. And if you factor that in by taking some return off of junk bonds as a compensation for additional credit risk, the resulting spread may not be better than the spreads on other corporate bonds.
“valuation has seen only limited extension into higher-risk markets” think about it… a “higher risk market” implies junk bonds (distressed credit of some fashion) where the probablity of a struggling borrower calling existing debt (that was likely issued when the borrower was a better credit) approaches zero since their options to refinance at a lower rate are unlikely. another way to think about it is again is when the value of an option is way out of the money, the option value is very low, hence the limited impact that option value would have on the spread analysis (where spread will be made up of more credit and liquidity risk)
If the option is way out of the money, why don’t the authors simply state that the z-spread and the OAS are virtually same? Instead the statement is “Given the exclusion of default risk from the OAS…” as though the exclusion is definitional for all credit bonds. Please look at the paragraph on page 76.
because Eddie Nero wrote the text
I do not believe the z-spread and the OAS are the same, though. Z-Spread + a constant spread = OAS and this makes the Market price of the bond = Discount PV of Cash flows. (for a bond that has embedded options in it).
“Given the exclusion of default risk in OAS option-evaluation models, OAS valuation has seen only limited extension into higher-risk markets….” ==> Option evaluation models do not consider default risk. So, the resulting OAS after removing just the option value is not a good measure of spread for comparison in higher-risk markets. Junk bonds have high credit/default risk hiding inside OAS. In summary, OAS is not a good spread measure for bonds with high credit/default risk.
So, if I understand you correctly… The text is not stating that the OAS excludes default risk. Rather, it’s saying that the OAS does not consider the effect that a default would have on the value of the option layer. Therefore, because the option value is unreliable where default risk is elevated, the OAS itself is not a good valuation measure. Please tell me if I have this right now.