Option Adj Spreads

CFA Level II Fixed Income
#1

If Interest Rate Volatility declines (thus call option prices decline) wouldnt Callable Bonds become more expensive since

P(Callable Bond) = P(Straight Bond) - Call Option and thus OAS would go up??

#2

Yes. As rate volatility increases (decreases) the OAS on a callable bond goes down (up) - inverse relationship with callable bonds.

Putable bonds are opposite - it is a direct relationship. If rate volatility increases your OAS goes up. If rate volatility goes down your OAS goes down.

#3

Perfect! Thank you.

#4

Walk yourself through the logic:

  • Interest rate volatility increases.
  • High rates are higher; low rates are lower.
  • Lower prices are lower; higher prices are higher.
  • Call options are more likely to be exercised.
  • Average cash flows are lower.
  • Discount rates are lower to reach the same market price.
  • OAS is lower.