I got this one wrong because I thought statement 2 was incorrect due to the inclusion of “modeling risk”. I was under the impression that the OAS represents compensation for only credit risk, & liquidity risk. Any comments on this?
I think the reason is that the oas spread is derived by estimating the spread over treasury spot at each maturity point with monte carlo simulation. The simulation is run until you are essentially able to force the model price = market price. You are correct that traditionally the oas spread only represents credit and liquidity if you are using treasuries as the bench mark. If the benchmark was one of similar credit quality or the same issue though, it would only be liquidity. It was a bit tricky for me as well, but I think the model risk enters into what is represented b/c of how the oas is derived.
Thanks Andrew.