Hi, can someone please help me understand why we can’t use z-spreads for option embedded bonds if the Z-spread is the one that includes credit, liquidity AND option risk? The OAS removes the option risk, so why we would we use that for bonds with embedded options?
Thanks in advance.
Suppose that you have a callable bond with a z-spread of 200 bp and an otherwise identical putable bond with a z-spread of 120 bp. Which one’s the better deal?
The answer is that you cannot tell, because you don’t know whether the 80 bp difference in yield is the fair value of the difference between the embedded options or not.
Suppose that the callable bond has an OAS of 150 bp and the putable bond has an OAS of 160 bp. Which one’s the better deal?
Now, clearly, the putable bond is better. You’ve removed the value of the call option and the value of the put option and you’re comparing two identical option-free bonds: you want the bond with the higher yield.
Aha! Makes perfect sense now. Thank you!
My pleasure.