Risk management Question

Option pricing theory can be used to explain credit risk premiums - for example credit risky corporate zero coupon bond can be seen as equivalent to a deult free zero plus a short put on the company asset can anyone elaborate on this? It doesn’t seem intuitive to me. Thanks!

This is somewhat like OAS to put it crudely… OAS = Z-Spread (spread stripped of the option) + Option-Cost Similarly, Credit Risky Corporate Bond = Zero-Default Corporate Bond + Short Put When credit risk goes high, you loose money on the short put.

thanks careerchange shouldn’t it be Z spread = OAS + option cost? Am i missing anything?

Z-Spread is not the spread stripped of the option. Z-spread is teh spread that is added to the if I remember treasury curve… OAS is simplest form the spread over treasures minus teh cost of the option.

Z-spread = OAS + option cost (is correct)

You’re correct I had a brain fart…I forgot that the OAS deals with the Treasury spot curve also…

Z spread means Zero volatility spread and implies that option cost is 0 (Zero vol = zero option cost if option is out of the money), so Z spread over treasury curve. as far as OAS and Z spread, you should always remember who benefits from writing options. If you buy callable bond you sell call option, so you need to be compensated by spread. If you buy puttable bond you buy put option so you pay with spread. so i guess option cost is negative in put option - cash otflow and positive in call option - cash inflow

thanks CSK. I was thinking the “x axis” as interest rate while “y axis” is the price of bond. So how does that related to short put on the company asset?