Evaluate MBS using OAS spread analysis ( LOS 53.e)

CFA Level II
#1

Hey guys,

I am quite confuse here. I’ve been looking at an example on OAS.

it says in a CMO tranches

Cheap securities will have high OAS relative to the required OAS and low option cost.

I am okay with the High OAS, you’re getting paid more for the undelying credit risk and liquidity risk

But wht would i like to get a low option cost? low option cost, means that you’re getting paid less for the prepayment risk that you are taking. Why would that mean a Cheap securities? i want both HIGH OAS and HIGH option cost since the embedded option is a call to the issuer and i get paid since i am short the option (so i want tohave high yield for it)

Can one of you guys help me with this. I am very confused and can’t figure this out even though i am looking everywhere.

thanks a lot.

#2

If Option Cost = Z-spread - OAS, then our OAS is going to be higher than Z-spread here and option cost will be negative (we’re short the option). So from this perspective the greater the OAS, the ‘lower’ the Option Cost because it becomes more negative.

#3

CMO TRAnches :

Tranche OAS Z-Spread Effective Duration

1 80 120 6.5

2 120 140 6.5

tranche 1 option cost = 120-80 = 40

tranche 2 option cost = 140-120 = 20

It says :

tranche 2 has a Higer OAS and a lower Option cost than tranche 1, and effective duration of the two tranches are equal, therefore:

Tranche 2 is undervalued on a relative basis, and should buy it

_ so here clearly option cost is positive, risk is similar, and they buy HIGH OAS LOW OPTION COST _

_ so the question is still why the option cost has to be low to be undervalued, since you’re getting less yield for same risk. still doesnt make sense… _

thanks for your help.

#4

Are they supposed to identically structured tranches?

#5

it doesn’t say. the only comparaison you have is the effective duration.

#6

OAS measures the spread you get after the option cost has been taken out. So you want the option cost to be as small as possible (ie less is taken out), making the OAS as big as possible.

#7

the option is the prepayment option and is held by the house owner, not the bond holder. with that said, the yield generated by the option goes to the bond holder since _ the house owner pay for the option to prepay _

_ Anyone else can help? _

#8

Just thinking as I am typing here, OAS = Z spread - Option Cost. Like you said, option is held by house owner and it represents the risk of prepayment, which would have a negative impact on the bond holder. Logically, lower the option cost, the better for the bondholder, because it represents less prepayment risk. The embedded option is a call to the ISSUER (house owner) thus HIGHER the option cost, HIGHER the value to the house owner, and the worse it is for the investor.

#9

Just thinking as I am typing here, OAS = Z spread - Option Cost. Like you said, option is held by house owner and it represents the risk of prepayment, which would have a negative impact on the bond holder. Logically, lower the option cost, the better for the bondholder, because it represents less prepayment risk. The embedded option is a call to the ISSUER (house owner) thus HIGHER the option cost, HIGHER the value to the house owner, and the worse it is for the investor.

#10

no because since the option is a call to the ISSUER (house owner), thus higher the option cost, higher the value the house owner will pay you to hold this option since ( if option cost is 50bps instead of 10 bps, the MBS holder will yield 40 bps more since the issuer is PAYING (house owner) the option cost).

it’s the same thing if I sell you a CALL on a stock. if the option cost is HIGH you will pay me MORE ( you’ll pay the MBS holder more money to have the call )

so if i am short a call ( like the bond holder in our case ), i want this call to have a very high initial cost since this is what I am getting for selling it to you.

still confused here… anyone else?

#11

You are in the trees, look at the forest.

Person buys home(borrower). He has the right to Sell home or Refinance. This pays off the Loan. Therefore, he is long the call option. Simple enough concept.

Bondholder is Short Call. Right? If you INCREASE Volatility, what happens to short call—it goes up in value, and you lose.

OAS = Z spread - Option Cost

If you are short an option or stock, you want it to go to ZERO.

if Option Cost = 0, then you are left with OAS = Z -Spread.

Hence you are compensated for the embedded Option.

In other words, The higher the option cost, the more you are paying for the prepayment risk. Zero option cost = Zero Prepayment risk…

The part that is not intuitive is that in a CMO that the timing of the cashflows are volatile, then the buyer of the bond is not sure which spot on the curve to price the security.

Example: 10 yr treasury = 3.5% yield

Investor buys IBM 10yr bond @ +150/10yr treasury.

There is no variablity in the payoff of the bond, so investor is certain he gets his 5% yield (3.5+1.5). This is a Z-spread, No option cost

CMO is different story. it is priced off Average life of outstanding loans, so uncertainy of the actual yield that will be earned. The OAS is spread after that uncertainity caused by the variability in the cash flows, caused by housing turnover and refinance incentive, has been removed.

The OAS over derived from MC sim over the spot curve in different interest rate paths, which attempts to factor in rising rates and slower prepayments.

Ponder this: If rates rise, does the OAS widen or tighten? What happens to Option cost?

If the model is 100% accurate for prepayments and Rates, then it stays the same. In reality, as the bond shortens over time, option cost shrinks. Lots of factors to consider.

I hope this explanation ends your mental gymnastics on this question. This you learn from sitting on trading desk for 15 years, not out of CFA book.

#12

You do agree that the house owner holds the call option and the house owner would exercise the call and prepay if the interest rate goes down and the price of bond becomes high, correct? Ask yourself in what circumstances would the value of this call be high? To name a few, when volatility is high and Rf is high. If I am looking at a MBS investment, these are characteristics I do NOT want. I want low volatility (less prepayment potential) and low Rf (lower opportunity cost). I think they key misunderstanding is that the option cost is not what the house owner will PAY you in the form of yield, but it is the VALUE of the call embedded in that extra yield you are getting on the MBS.

#13

Thanks Kedgar. I seriously read your post 5 times. Very interesting and informative. I think what I was missing is the fact that the yield you see is not the yield you’ll got.

Thanks for your time. you should post more often

regards.

#14

This is technically mistated. "but it is the VALUE of the call embedded in that extra yield you are getting on the MBS.

Investor is not recieving the yield. The purpose of the OAS is to quantify the actual yield compensation after the option is removed, hence the name “option Adjusted Spread.” Investor is short the option,.

OAS = Z spread - Option cost.

It is the spread without the option.

#15

Kedgar, what you said is ultimately what I meant unles I am misunderstanding something. OAS = Z spread - Option cost so I was saying that the option cost is embedded in the z spread. Once you remove the value of that call option the house owner is holding, then you will reach the OAS. Let me know if I’m missing something here. Thanks.

#16

You have to think of this intuitively:

Think about the term in the book, “Path Dependency”

If you ran your Interest rate model with an opinion of rates declining and this is a support tranche, then the support with absorb all the prepayments that will be caused by refinancing and the bond will dramatically shorten and will be priced with a high option costs. Vice Versa if rates rise.

By using MC sim, the model attempts to ascertain all outcomes and determine a fair value for the option, and remove the option to quantify what you can expected to earn. Each Path gives a different outcome and spread. They add them up and come up with an average to determine the bond price.

Go re-read Path Dependency, you will see it in a different light.

#17

Kedgar,

If I understand corectly, OAS is what I should get if everything goes accordingly to my future CFs assumptions.

If I look at a Z spread on a CMO ( because i would assume that this is the quote you can see on the market ) I can make assumption on my future CFs, evaluate the OAS, and calculate the embedded option cost. the Z spread does not tell me how much i will make, it only tells me the value of the embedded option in fonction of my assumption.

Is that right?

thanks.

#18

SKwak88,

your understanding is correct, but your wording is not and leads to misinterpretation. stating “extra yield you get” is the problem. You “get it” only if Volatility = Zero. Another fine point is that there is a question somewhere I answered specifically states that “On bonds with uncertain cash flows, I.e. MBS” , the proper way to determine their value is OAS, not Z spread.

You use OAS to compare two securities with similiar cashflows with uncertain outcomes to determine which is a better value. Higher OAS, Lower option cost, shorter duration.

Use Z-spread for ABS and Corporates.

Start at pg 492, Fixed income. It discusses which spread measure to use on which type of bond. I have seen it in practice questions.

#19

ok thanks Kedgar for you time an explanation!

#20

Summerside82, I now understand why you don’t get it. Re-read starting Pg 492. Bonds that do not have embedded call options are valued/trade at Z-spread. CMO’s trade to OAS. The reason you look at the Z-spread on a CMO is to determine the optionality i.e Volatility in the cashflow of the bond. The less the option cost, the greater degree of certainty that you might actually earn the OAS. If the cashflow is stable, the option cost will be low. The option cost can be thought of as a in terms of a measure of the volatility of the Cash Flow. If you increase the Volatility of the interest rate paths the option cost will be higher on an unstable cash flow. These are all the risks that are reducing what you get, which is the OAS. In another way, MBS Option Cost = Volatility of Interest rate paths + Interest rate Modeling risks + Actual Prepayment risks + Prepayment Model Risks. On a corporate, it is based on an option mode, different animal.