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FIXED INCOME -- Interest Rate Volatility and OAS

I have a few questions about the following statement that was made in R37 (Summary), excerpted as: “OAS is sensitive to interest rate volatility: The higher the volatility, the lower the OAS for a callable bond.”

1. For a callable bond, wouldn’t one expect the OAS to be greater than its equivalent for a putable bond because it is the bondholder that is taking most of the risk ?

2. Why does the author use the term “lower” as opposed to “smaller” ? I thought OAS was a positive spread that was added to the yield curve to recognize the added uncertainty of the presence of embedded options in a bond ?

Thanks all for your insight.

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mc2cfo1 wrote:
I have a few questions about the following statement that was made in R37 (Summary), excerpted as: “OAS is sensitive to interest rate volatility: The higher the volatility, the lower the OAS for a callable bond.”

1. For a callable bond, wouldn’t one expect the OAS to be greater than its equivalent for a putable bond because it is the bondholder that is taking most of the risk ?

2. Why does the author use the term “lower” as opposed to “smaller” ? I thought OAS was a positive spread that was added to the yield curve to recognize the added uncertainty of the presence of embedded options in a bond ?

Thanks all for your insight.

OAS removes the value of embedded options, so the OASs for a callable bond, an otherwise identical putable bond, and an otherwise identical straight bond should all be the same.

“Lower” covers the possibility of negative spreads in a way that “smaller” does not.

Simplify the complicated side; don't complify the simplicated side.

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Awesome. That makes sense. Thank you ! smiley

You’re quite welcome.

I rarely make sense on Monday mornings.

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

I don’t know if you’re solid on this but I was using some of Mark Meldrum’s content. The book had me really confused on this then Meldrum showed the equation that Z Spread = OAS + Option Cost.  That really clicked for me. So there is that chart on page 148 (Reading 36, perhaps this is what you meant, not 37) which is Exhibit 16 “Effect of Interest Rate Volatility on the OAS for a Callable Bond”…

So as the int vol increases the option cost/value increases and as we know the z spread is constant, the increasing size of the option cost has to “suppress” the OAS…. 

I know a teensy bit about this stuff.  (Analyzing MBSs and CMOs at PIMCO for 6 years will do that to you, I guess.)

I don’t know what it means to “suppress” the OAS.

I presume that the interest rate volatility to which you refer is the assumed volatility in a binomial interest rate tree.  The market price of the callable bond is given (i.e., fixed), and I think of it this way:

  1. When the assumed volatility increases, the high interest rates in the tree are higher, and the low interest rates are lower.
  2. When the low interest rates are lower, the bond is more likely to be called.
  3. When the bond is called, the cash flow at that node is lower.
  4. When the bond is more likely to be called, the average cash flows in the tree are lower.
  5. To discount lower cash flows to get the same price, you need lower discount rates.
  6. To get lower interest rates, you need a lower OAS.

Simplify the complicated side; don't complify the simplicated side.

Financial Exam Help 123: The place to get help for the CFA® exams
http://financialexamhelp123.com/

Hi all,

I have few queries from the reading “The term Structure and Interest rate Dynamics”

1. What is meant by bootstrapping please elaborate with an appropriate example.

2. How does bond valuation done using Swap rate curves ??