I’m confused as the whether we are using OAS for valuation purposes or for comparison purposes?

Im going to follow Schweser to ask my question more clearly or explain my confusion more clearly. Z spread (according to schweser books) is the spread that when added to each spot rate on the yield curve, makes the present value of the bonds’ cash flows equal to the bond’s market price. Therefore is a spread over the entire spot rate curve. So let’s say

1. We have a bond with a 1 year spot rate of 4%. Z spread is 80bps, thus instead of discounting the bond with 4% we now discount the bond with .04008 first year and .05008 second year (5% is the spot rate for the second year)

2. We have a bond with an embedded CALL option, so we use the OAS because Z spread is not appropriate to use to value bonds with embedded options.

3. And let’s say that option cost is 10 bps for a callable, so 1 year is OAS = 80bpbs - 10bps=70bps. So our OAS is 70bps and now we discount the bond with .04007, which is LESS than .04008. Lower yield means higher price, so my question is WHY would a bond with an embedded option be valued with a LOWER yield? Bonds with embedded options should have HIGHER yields not LOWER.

Am I wrong for using OAS to value option embedded bonds? Is OAS just for comparison purposes but not used to VALUE embedded bonds? Are we removing the option price from the Z spread so we can compare to other similar option free spreads, but not to value?

Any insight would be much MUCH appreciated. Thanks!!!

Suppose that you had a 10-year, \$1,000 par, 6% coupon, semiannual pay, callable corporate bond with a Z-spread of 150bps and an OAS of 90bps. The 150bps spread is the spread over the (zero-volatility) Treasury spot curve that gives you the price of that bond. The 90bps spread is the spread over the (_non_zero-volatility) Treasury spot curve that gives you the price of a 10-year, \$1,000 par, 6% coupon, semiannual pay, _ non _callable corporate bond.

You don’t use the OAS to value the bond in question; you use it to compare the bond in question to other bonds.

S2000 magician, you are AWESOME. Thank you. It makes sense.

My horse thinks so. When I give him carrots, apples, or peppermints.

You’re quite welcome.

That’s what’s important.

S2000magician, you should write for one of the prep companies, you make these things sound so much more intuitive than they do with their long explanations that make less sense.

I second that!