Question asks: In computing the effective duration and convexity of a bond with an embedded option, what assumption is made about the option adjusted spread when rates change.
Me: well… if rates change… the OAS must change in order to arrive at the correct arbitrage free market value of the bond. They change but remain constant.
CFA answer: its assumed the OAS remains contant when rates change?
Please help me?
OAS does not change, Rasec. You initially start with a a bunch of interest rates and find the value of the bond. As part of this initial process, you also interpolated an OAS. Let’s say this OAS is 50bps.
In order to get to convexity/duration, you “shake up” the interest rate tree while keeping the OAS at 50bps (the original value). So the only thing that changes is the interest rate tree (and the new price of the bond).
I think I got it! thanks again!
can I check for finding the effective duration of an option-free bond using an interest rate tree, is there a need to regenerate the tree after adding a constant amount to each of the 1-year rate before valuing the bond?