OAS / Z Spread + Options

CFA Level II Fixed Income
#1

For bonds with emebedded options which is the mesuaure of spread we use? The OAS or Z spread? I have read the OAS spread is more useful, but given the below definitions I don’t understand why the OAS spread is a better measure? Panic setting now, any help would be greatly appreciated. Thanks

The OAS is the spread over a non-zero -volatility Treasury spot curve that eliminates the value of any embedded options.

The Z-spread is the spread over the zero -volatility (hence the “Z” in Z -spread) Treasury spot curve that includes the value of any embedded options.

Cheers for any reponses.

#2

For bonds with embedded options, use OAS.

OAS removes the value of the options, so it lets you compare option-free bonds to option-free bonds.

Same scale.

#3

Great makes sense, heart rate returning to normal levels :slight_smile: Really appreciate your feedback.

#4

My pleasure.

#5

How does OAS relat to prepayment options on bonds?

#6

It eliminates their value.

#7

Since you’re dealing with embedded options, certain paths in the interest rate tree result in the bond being called or put. So essentially, certain paths of the tree are truncated. The OAS is a constant spread added across these remaining interest rate paths. As a result, the OAS is just a spread that reflects liquidity and credit risk and does not include the option cost.