Would someone help me out about the OAS?

CFA Level I Fixed Income
#1

HELLO,

I’m suffering understanding the OAS.

First, I have learned that in the process of pricing the corporate bond, the spread that is added to forward rate would be upward-sloping. That means the first coupon would be discounted with 1+f(1)+s(1) and the second coupon would be discounted with 1+f(2)+s(2).

But in the example of the CALLABLE BOND, OAS is a spread in which option cost is eliminated from the Z-spread. And therefore OAS and Z-spread would be a curve that is parrallel to the US treasury. This does not accord with the fact that sector-specific spread is different on every period.

And also, I do not get why investors do calculate the OAS and how can they do that? I have understood as the following process; If the maket price of security is given, I can depict the Z-spread. And then using the bionomial tree or through Monte Carlo Simulation, get the value of the option and eliminate from the Z-spread. Is it correct?

I have so hard time understanding about it and so it would be SUPER THANKFUL who can answer to my question. Thkns.

#2

OAS (presumably) eliminates the value of any embedded options, allowing a comparison between option-embedded bonds and option-free bonds.

#3

Thanks for answering. May I ask you one more?

I saw your reply on other question. It says that OAS is added to forward rates to get the market price. Why does OAS is added instead of the Z-Spread? In the case of the callable bond, investor expect higher yield as a reward of the call option. And as i understood that added yield because of the option is embedded in Z-Spread.

Thanks a lot.

#4

Because in a binomial tree the value of any embedded options is removed, so the spread has to have the option value removed as well. OAS has the value of the options removed; z-spread does not.