OAS

CFA Level II Fixed Income
#1

For some reason I can’t wrap my head around the OAS (option adjusted spread). If volatility increases, the OAS for a callable bond decreases? This doesn’t make sense to me because if volatility increases, the value of the call increases and the value of the bond falls right?

thnx!

#2

I wrote an article on OAS here: http://financialexamhelp123.com/option-adjusted-spread-oas/.

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To answer your question, here’s the reasoning in a nutshell:

When you increase the volatility in your binomial interest rate tree:

  • The high interest rates in the tree will be higher, and the low interest rates in the tree will be lower.
  • The lower the low interest rates, the higher the present value of the remaining cash flows.
  • The higher the present value of the remaining cash flows, the more likely it is that the bond will be called.
  • When the bond is called, the lower the cash flow at that node, so the lower the average cash flows for the entire tree.
  • The lower the average cash flow, the lower the average discount rate needed to get to the same present value.
  • The lower the average discount rate, the lower the required spread (OAS).
#3

so helpful- thnaks!

#4

My pleasure.