Schweser on convexity calculation with trees on bonds embedding options.

Here is the Schweser:

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An analyst has constructed an interest rate tree for an on-the-run Treasury security. The analyst now wishes to use the tree to calculate the convexity of a callable corporate bond with maturity and coupon equal to that of the Treasury security. The usual way to do this is to calculate the option-adjusted spread (OAS):

**A)** compute the convexity of the Treasury security, and divide by (1+OAS). **B)** shift the Treasury yield curve, compute the new forward rates, add the OAS to those forward rates, enter the adjusted values into the interest rate tree, and then use the usual convexity formula. **C)** compute the convexity of the Treasury security, and add the OAS.

**Your answer: C was incorrect. The correct answer was B)** shift the Treasury yield curve, compute the new forward rates, add the OAS to those forward rates, enter the adjusted values into the interest rate tree, and then use the usual convexity formula.

The analyst uses the usual convexity formula, where the upper and lower values of the bonds are determined using the tree.

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So if we take the steps on the Schweser they use the OAS, thus taking out the Option, but wether it is a callable or putable bond each one of the option has an impact on convexity, isn’t it?

Thanks again,