Why is it that credit spreads widen with interest rate volatility?
Because it shows the economy is not stable. An economy may not be stable due to various factors, eg. war, terrorism, economic problems etc. So there is more risk of defaults to less than investment grade securities.
This is why: Z-spread=OAS + Option Cost So as interest rate volatility increases, option cost increases and Z-spread (which is the spread on the entire yield curve) increases or widens. Anybody can confirm?
mik82 Wrote: ------------------------------------------------------- > This is why: > > Z-spread=OAS + Option Cost > > So as interest rate volatility increases, option > cost increases and Z-spread (which is the spread > on the entire yield curve) increases or widens. > > Anybody can confirm? That is true. But it does not answer the original question. It refers to credit spreads response to rise in interest rate volatility. In essence the question is why does OAS rise when interest rate volatility increases?
dtrynoski, Are you referring to OAS or credit spreads in general?
As interest Vol increases you are looking at more market risk taking a fixed income position, thus a increased return is needed to compensate this risk.
To my understanding, OAS for callable bonds decreases as interest rate vol increases. However, OAS for MBS increases as interest rate vol increases because MBS investors have sold the option to homeowner (in contrast to callabe bonds where issuers own the option).
mik82 Wrote: ------------------------------------------------------- > To my understanding, OAS for callable bonds > decreases as interest rate vol increases. However, > OAS for MBS increases as interest rate vol > increases because MBS investors have sold the > option to homeowner (in contrast to callabe bonds > where issuers own the option). OAS, to my understanding, is the spread that a callable, putable or MBS will have when the option is stripped off. That is the reason it is called option adjusted spread. The OAS will take on the characteristic of an option free bond spread. The OAS of an MBS and callable and putable bond and the spread on an option free bond should therefore react to interest rate volatility the same way. Thus the higher the interest rate volatility, an input into bond pricing models, the higher the spread (OAS) should be and the lower the interest rate volatility, the lower the spread. The question now is why does high interest rate volatility lead to higher spread? I will take a stab at this. I believe the reason why high interest rate volatility leads to higher spread is because high volatility is due to uncertainty in the economy and the higher the uncertainty the higher the risk of default from bond issuers. Hence this uncertainty is incorporated into the higher spreads.
FWIW, in http://www.newyorkfed.org/research/epr/08v14n1/0807rose.pdf (“Signal or Noise? Implications of the Term Premium for Recession Forecasting”) footnote 5 cites several sources: Vasicek (1977) shows that the term premium depends on interest rate volatility and the maturity of the bond. Several empirical papers confirm this relationship. Hamilton and Kim (2002) find that the term premium is closely linked to long-term interest rate volatility, while Orphanides and Kim (2007) identify a strong relationship between the term premium and the dispersion of inflation forecasts. Beechey (2007) shows that most of the response of ten-year forward rates to macroeconomic news comes from changes in the term premium rather than expected future short-term rates. Granted, TP is generally spoken of in reference to risk-free rates, but credit spreads themselves show a term structure, and I would guess that the same factors causing TP in treasury rates apply to credit spreads as well.
Thanks for sharing a very intersting paper, DarienHacker.
AS IR becomes more volatile the cost of the option increases, as the cost of the option increases the OAS spread becomes SMALLER not bigger leading to a high price to the underlying.
insightful papers concluded this arguments: higher volatility and higher premium are correlated. But the poster may want to know how to explain this in theory not statistical examination. Charles
ok so you are an investors and lo and behold interest rates starts to get volatile jeeez louise wat the hell anyways u need to mark the entire market …well u tell me jack GE cocca cola, apple microsoft etc are blue chip so credit spreads movements for these will be fairly flat…but for the high yield markets well you just forget it i neeed greater compensation for that junk …hence higher credit spreads for this sector… basically what idreesz posted