Given the table below, the question asked us to pick the MBS that offers the highest value relative to the cost of the option. (Question wants us to assume the effective durations are the same for all.) MBS Initial Principal ($millions) Coupon Rate Underlying Maturity (years) Nominal Spread OAS__Z-spread W 250 7.0% 30 1.21% 0.28% 0.79% X 175 7.8% 25 1.43% 0.49% 1.16% Y 225 7.2% 20 1.62% 0.31% 1.12% Z 190 8.0% 30 1.59% 0.40% 1.14%
MBS-X has the highest OAS relative to the cost of the option embedded in the MBS. Therefore, it is the most attractive of the four alternatives. I don’t understand why we look at the OAS relative to the cost of the option? Why would this show us which investment has the most value relative to risk? Why can’t we just look at the Z-spread for this purpose? Maybe since the question tells us to assume the effective durations are equal, we are supposed to assume the same intrerest rate risk for all of these investments, and therere we move on to risk relative to the cost of the option? Bottom line- it seems like if the question asks to pick the investment with the higest value relative to risk, it seems to me like the Z-spread would do that- and I can’t wrap my head around why we’d look at the OAS spread relative to the cost of the option (Z spread- OAS) thanks!
Sorry the above post didn’t come out too well…my question is essentially below:
I don’t understand why we look at the OAS relative to the cost of the option to look at ‘value releative to risk’ for a particular investment? Why would this show us which investment has the most value relative to risk? Why can’t we just look at the Z-spread for this purpose?
Maybe since the question tells us to assume the effective durations are equal for all given investments, we are supposed to assume the same intrerest rate risk for all of these investments, and therere we move on to risk relative to the cost of the option? Bottom line- it seems like if the question asks to pick the investment with the ‘higest value relative to risk’, it seems to me like the Z-spread would do that- and I can’t wrap my head around why we’d look at the OAS spread relative to the cost of the option (Z spread- OAS)…doesn’t that only give us a value RELATIVE to what the option costs? thanks!
OAS removes the effects of embedded options; it allows you to compare various bonds with different embedded options.
The simple rule is: choose the bond with the highest OAS.
sorry 1 quick question on OASs…
if volatility increases- what happens to the OAS? I think the answer should be nothing since volatility increases the value of options but doesn’t change the OAS spread right?
I wrote an article on OAS that may be helpful here: http://financialexamhelp123.com/option-adjusted-spread-oas/
The short answer is that if you increase the volatility assumption in your binomial tree:
- The OAS of a callable bond will decrease
- The OAS of a putable bond will increase
ahh yes I get it now! I think I was not thinking about how to we’d literally adjust the CFs in the tree as you showed…that was super helpful thanks!
You’re quite welcome.
The thought exercises I had in that article are, in my opinion, particularly useful: average cash flows on callable bonds decrease as volatility increases; average cash flows on putable bonds increase as volatility increases.