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.

You’re quite welcome.

I rarely make sense on Monday mornings.

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.