On page 60, 1st Para states " OAS tends to widen when expected volatility increases…" I thought higher the interest rate volatility , lower the OAS. Can someone please explain ?
here’s my take… OAS is used to remove the effect of embedded options in securities… so if expected volatitlity is increasing, the embedded options would be more valuable and the OAS spread would widen for that group of securities because of the increase in the embedded option. From the sellers point of view, if the underlying option is expected to become more valuable, then the seller will require more return - increasing the spread - in order to want to sell the original security.
Striker - Thanks… I still don’t get the relationship between OAS and value of option. This is what I recall - OAS = Z spread - Option cost When an investor sells the prepayment option to homeowner then the option cost is positive from the investor’s perspective. In case of increase in volatility, cost of option increases which means OAS decreases. Also, (somewhat related) I see on page 57, under Interest Rate Risk the author says “portfolio manager cannot capture all of the spread as some needed to cover the value of option”. Why would the investor who is selling the option need to cover the value of the option ? Kind of confused… Thanks for your help!
On page 60, perhaps it will help if you think of it in the context of the future. I’m getting ready to sell a bond with an enbedded put option so the buyer of the bond will value my offering as follows: bond value = straight bond + put option (so i value it as a straight bond minus a put option). If I, the seller, expect volatility to increase in the future, then i know the option will become more valuable, so i must increase the spread of my offering to counteract that. In other words BV = SB - PO and if PO is expected to increase in the future, then i must increase the spread of SB to the approprate treasury to offset the increase in the put option… does this help more?
Yeah, the option is more valuable if volatility is up, and therefore the spread between what the bond is worth with the option and just as a straight bond widens. So, OAS tends to widen [relative to Z-spread] as volatility increases. Now the question is who gets the benefit of the option. If you have a callable bond, then the issuer pays you for the call privilege, which raises the yield (or lowers the price, same thing). Effectively, you are getting more yield in compensation for the increased risk of having the bond called away. If you have a puttable bond, then you’re paying more than for the straight bond to compensate for the put privilege (and thus lowering the yield in compensation for less risk). In either case, the effect of the option is wider with greater volatility.
Now just a second - OAS is supposed to be the spread of the bond over a risk free bond when the effects of optionality are removed. Essentially, OAS is the spread the bond is selling for if you throw away all the options. If there are no options in the bond then volatility shouldn’t effect the bond price. Unfortunately, that explanation isn’t quite right but why it isn’t quite right depends on the bond scenario and what “expected volatility” means. OAS is really fundamentally different from Z-spread or ytm because it’s the result of some model driven process (even though Bloomberg will spit out some OAS, there is no reason to believe it).
Oh, that’s right. OAS is the difference between the yield on the option bond over an equivalent risk free bond, while z-spread is the yield due to credit risk and any non-option risks. I’m glad that test day isn’t today… and that I don’t have a FI job where that matters. 
So the difference between OAS and Z-spread will widen with expected volatility, but OAS may actually get smaller for a putable bond, since you get less yield for added safety. Callable bonds will have higher OAS when your model assumes higher volatility, since you get more yield as payment for putting up with the call.