In example 3 of CFA notes and p.305 on Schweser notes stated that,
a bond with embedded put option would likely to have its OAS exceeds the Z-spread, while a bond with embedded call option would likely have its OAS below the Z-spread.
Why is that?
I don’t understand the explanation stating “OAS exceeds the Z-spread because it captures the potentially favourable impact of the put feature on the investor’s return.” Why a favourable feature will cause OAS exceeds the Z-spread? Shouldn’t it be the other way?
Both the OAS and the Z-spread are spreads added to some base interest rates which are then used to discount the bond’s cash flows to arrive at the bond’s price today. (I’m simplifying here, but the basic idea is correct.) The OAS removes the effect of the put option, while the Z-spread does not. Therefore, the OAS is a spread for the option-free bond, while the Z-spread is the spread for a putable bond.
The price of the putable bond will be higher than the price of the option-free bond, because the bondholder is also buying a put option which is favorable to him.
Therefore, the OAS is a spread needed to get to a lower price than the Z-spread with the same cash flows. Thus, the OAS is higher than the Z-spread.
(Yes, there are a lot of important details I’ve omitted, but the basic argument is sound, and the details will only clutter things up here.)
This is stuff that was (or, rather, should have been) covered well at Level II.
Z-spread is to get spot price of a bond = pv of cash flows along curve w/o any adjustment for embedded option. With options here, a call provides value to the issuer, a put provides value the investor. Value added to the bond (in this case the put) is reflected in price, which when discounted back to spot px, you need a HIGHER yield, IE OAS spread.