Ned Jameson, CFA, is considering the purchase of a newly issued asset-backed security (ABS) for his fixed income portfolio. According to the broker/dealer offering the bond, the OAS for the issue is 75 bps. Based on the OAS value, which of the following assumptions can Jameson make about this particular ABS? Statement: The implied cost of an option embedded in the security is always equal to the difference between the OAS and the Z-Spread. I don’t really understand why the statement is incorrect. Isn’t that the definition for cost of an option?
Z-spread = OAS + Option cost Option cost = Z-spread - OAS Sounds like Ned’s statement has it the other way around.
Thank you! Can anyone also please explain to me why the earlier bond principal is paid, the greater the difference between the two spread measures?
difference between the nominal spread and the Z-spread for a security, that is
I am assuming you are asking about a form prepayment risk. If the bond principal is repaid earlier (by having the bond called), you are now affected by reinvestment risk. You get pay for this risk in term so options risk. If the option favors the issuer, option cost is higher thus Z spread is higher.
frangoya Wrote: ------------------------------------------------------- > difference between the nominal spread and the > Z-spread for a security, that is because nominal spread is a static spread. where as Z-spread considers the option cost. as more principal is returned, the OAS spread will go down, bringing the z-spread down, and the option cost’s will fall. where as for nominal spread, nothing changes.