Regarding CMO, if we calcualte the spread of OAS = Z-spread, can we say it has no prepayment risk? Thanks.
no
z spreads and OAS has got nothing to do with Prepayment Risk…
That’s an overstatement.
The OAS removes all optionality. If there is a prepayment option, then the OAS will reflect it (it will cause the OAS to be less than the Z-spread). The only way that the OAS and the Z-spread will be equal when there is a prepayment option is if there is an offsetting option that favors the bondholder; e.g., a put option. Thus, it’s not universally true that OAS = Z-spread means that the bond has no prepayment risk.
Thanks.
But I’m not fully sure if I get it. If there is a put option, OAS should not equal to Z-spread.
So why “The only way that the OAS and the Z-spread will be equal when there is a prepayment option is if there is an offsetting option that favors the bondholder; e.g., a put option”
Recall that OAS removes the value of all options.
If there is a net option favoring the issuer, the OAS will be less than the Z-spread.
If there is a net option favoring the bondholder, the OAS will be greater than the Z-spread.
Only when the net option is zero will the OAS equal the Z-spread. Thus, if there is a prepayment option (which favors the issuer), then there must be an offsetting option (e.g., a put option) that favors the bondholder.
Many thanks!
Want to clarify prepayment option can favor bondholder as well?
No, the prepayment option favors the issuer. (In a CMO, it really favors the underlying mortgagee; the homeowner.) People prepay most often when interest rates are low (i.e., they refinance their loans). This is a disadvantage to the bondholder; you don’t want to get your money back when interest rates are low; you want to get your money back when interest rates are high (so that you can reinvest at a high rate).
Got it. It’s very helpful!
Good to know.