OAS Volatility Question

CFA Level II Fixed Income
#1

Hi all, I had a quick question and was hoping someone could help me understand the following:

All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. Rogner computes the OAS of bond A to be 50bps using a binomial tree with an assumed interest rate volatility of 15%.

If Rogner revises her estimate of interest rate volatility to 20%, the computed OAS of Bond B would most likely be:

Why is the answer lower than 50 bps?

Because if she increases the interest rate volatility, then wouldn’t the call option value increase which causes the value of the callable bond to decrease. So since the price would be lower, wouldn’t the OAS needed to match the lower price need to be higher than “normal” (the 50 bps)?

#2

volatility goes up, which means that value of call option will go up. this will make the value of callable bond decrease, which make the OAS for callable bond decrease.

Also, OAS= Z- option value. since option value increase, OAS has to decrease.

I believe there is a box in the curriculum that show these relationship. you should check it out.

#3

The same question was (or is) discussed excessively here:

https://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91358437

#4

Thank you both. Appreciate all the help.

#5

This last bit would probably benefit from a little explanation; it’s not as obvious as the first two steps.