“It is my understanding that as interest rate volatility declines, the OAS for callable bonds decreases while the OAS for putable bonds increases.”
The statement is incorrect.
As interest rate volatility declines, the embedded call option becomes cheaper; thus, the higher the arbitrage-free value (or model value) of the callable bond.
Callable bond value = Value of straight bond – Value of call option
A higher value for the callable bond means that a higher spread needs to be added to one-period forward rates to make the arbitrage-free bond value equal to the market price (i.e., the OAS is higher).
Could any one explain the answer? I just think that the call option is price less while volatility declines, and the price of the callable bond increase, so the OAS decrese. [Price=CFi/(1+ri+OAS)]
Hi guys, this is what i could figure out of this question:
When the interest rate volatility is decreasing, this leads to the decrease in the value of the embedded call option;
When the value of the embedded call option is reduced, then the price of the callable bond will increase, because callable bond = straight bond - value of the embedded call option;
Your goal here is to make the callable bond value equal to market value, i.e. you need to somehow decrease the callable bond value. For doing this you need to add higher spread to the discount rate to make the bond value decline.
Note, that this is the only explanation that I can give to myself from reading the explanation provided by CFAI.
The OAS is the price spread between the option bond and risk-free bond.
so, if the value of call option is decrease, the callable bond price is increase and near to the risk free bond, which means the spread is lower, OAS decrease.