Interest rate volatility and OAS

CFA Level III
#1

Yes, this is an old question, but it’s asked in a slightly different way.

If the interest rate volatility rises, all else equal, what happens to

  1. OAS of a callable bond?
  2. OAS of a MBS?
  3. Z-spread of a callable bond?

Thanks.

#2

1.decrease

2.increase

3.increase

?

#3

PCallable = PNonCallable - PCallOption

When Interest Rate volatility increases PCallOption goes up - so PCallable goes DOWN.

Same should apply for a MBS as well, as an MBS is a call option from the Investor’s viewpoint - and if price of the MBS stays the same - the same decline in Bond Value should happen.

Since the Price of the Callable bond goes down when Volatilty goes up - the Z-Spread should go UP.

#4

i like how tulkuu always has some fun mini quizzes for us

#5

now that we’ve had 2 incorrect answers, here is the correct answer one:

  1. decrease

  2. decrease

  3. no change

#6

Well, the value of the option goes up, so you’ll get an increase in the value of the options (ie prepay, calls) so you’ll get a decrease in the prices of all three bonds. This will boost the z-spread of the callable bond.

Option cost = z-spread - OAS, so the OAS in both cases would decrease.

#7

so tulkuu…what is the answer pls?

#8

  1. decrease

  2. Increase

  3. No change

is my answer…

#9

My answer is the same as Rahul’s. The answer may depend on the way it was asked. Z-spread is zero-volatility spread, which should be independent of the volatility. Assume the price is not changed in 1) and 3). 2) is from text book on MBS, but it assumes the MBS price goes down when the volatility increases. By the way, OAS also depends on the model used.