OAS and default risk

sin what does “ms” mean in your comment?

zoya Wrote: ------------------------------------------------------- > sin > what does “ms” mean in your comment? Midswaps. It’s what you use to compare all bonds in the markets

interesting. thanks.

Just remember sins is 100% correct in practice. But if the question asks what is one of the problems with the OAS model, you better put down on the piece of paper, “Does not include default risk.” Same thing for credit spread options. Although a put in practice definitely means credit spreads are going to widen for the tests it is a call.

CFAI Reading 31, page 168, states that investment in mortgage securities has 5 principal risks, and credit risk is not one of them. So the OAS does exclude default risk. Possibly, this is so because residential agency mortgage-backed securities have an implicit government guarantee - thus, for these securities default is not an option (pun intended).

Jose G. Wrote: ------------------------------------------------------- > CFAI Reading 31, page 168, states that investment > in mortgage securities has 5 principal risks, and > credit risk is not one of them. > > So the OAS does exclude default risk. > > Possibly, this is so because residential agency > mortgage-backed securities have an implicit > government guarantee - thus, for these securities > default is not an option (pun intended). I’ve just checked that page and it doesn’t say that at all. Spread risk captures the credit risk of the rmbs amongst other things

CFAI Reading 31, page 168, second paragraph says: “…There are five principal risks: spread, interest rate, prepayment, volatility and model risk”

Jose G. Wrote: ------------------------------------------------------- > CFAI Reading 31, page 168, second paragraph says: > “…There are five principal risks: spread, > interest rate, prepayment, volatility and model > risk” Yes, but what is spread risk? Spread risk is the risk that the CREDIT spread will widen because of perceived or actual reductions in credit quality. This is the whole concept underlying spread options and relative value trading (credit defence / upside trades)

Let sins get it wrong. Again, industry practice has very little reference in the CFA curriculum. Look at credit spread options for an example.

CFAI Reading 31, page 168, second paragraph also says: “…the yield of a mortgage security - the cumulative reward for bearing all five of these risks -has two components: the yield on equal interest-rate risk Treasury securities plus a spread. This spread is itself the sum of the option cost, which is the cost of bearing prepayment risk, and the OAS, which is the risk premium for bearing the remaining risks, including model risk.”

It is incredible. A few days before level III exam, and AF’s "best and brightest’ are deeply engaged in a level I and II terminology. The problem is you are arguing past each other because of confusing terms. Let’s step back guys. - OAS modeling ASSUMES that the bond in question is NOT going to be defaulted (at least not for the assumed interest rate volatility). Remember the binary tree used in level II: none of the nodes has default as value. Therefore OAS is good for comparison of (similar) investment grade bonds since those bonds are unlikely to default in standard volatility scenarios. - Agency MBS has implicit guarantee of the US gov thus assumed to be default-free (or at least investment grade) thus appropriate for OAS modeling. - Junk bond has high default risk thus not appropriate for OAS modeling. - OAS is good for comparison between option-free and option-embedded bonds with similar investment graded credit rankings (and between option-embedded bonds even though you’d get same conclusion using z spread) since the OAS ‘removes’ the extra spread one pays for the option (option price) from the z-spread thus make it comparable between bonds with options and bonds without. The confusion is due to the definition of ‘exclude’ - OAS excludes option risk: OAS removes the option price. All other risks remain (model risk, interest rate risk,…), even though it is not appropriate to address default risk (see below). - OAS excludes default risk: It actually means the OAS methodology excludes the possibility of default. OAS modeling assumes no default thus does not take default into account. OAS is not appropriate to be used for high risk option-embedded bonds. The OAS number DOES include the default risk, but it is meaningless in the same way as you use DCF model for a start up firm using risk free rate as discount rate (or one may argue that it is inappropriate to use a DCF model for a start up at all). PS: Paraguay, I agree with you about the credit spread option convention used in the CFAI book. It seems to be opposite with standard industry convention, i.e., CFAI calls “credit spread call” while one would normally call the same option a “credit spread put”.

Here’s an MBS related question: Schweser and Stalla say you can’t hedge spread risk. However, the book phrases it in a way such that the manager would not want to hedge spread risk, which makes sense. So can spread risk be hedged or not? I’m saying you still can, but otherwise why even bother investing in an MBS.

This is my take on this: - CFAI material has not taught explicitly how to hedge spread risk, i.e., change in spread, apart from just saying ‘managed by investing heavily in MBS only when the initial OAS is large’, so it is inconclusive to say yes or no according to the material. Can you? Of course you can. One of the methods is to use credit derivatives, e.g., buy an credit spread call (or credit spread put as per normal convention, see my posting above), but it costs to do so, therefore the CFAi also says that it does not make sense to hedge it since it is the premium you earn by investing MBS.

elcfa Wrote: ------------------------------------------------------- > PS: Paraguay, I agree with you about the credit > spread option convention used in the CFAI book. It > seems to be opposite with standard industry > convention, i.e., CFAI calls “credit spread call” > while one would normally call the same option a > “credit spread put”. Why would use a credit spread put? I’m thinking that normally with any long put, you make money when the underlying decreases. So if buy a credit spread put, it seems to me that you would make money when the credit spread decreases. But you would already be making money when the credit spread decreases because the price of your bond would increase wouldn’t it? So it’s not a hedge, it’s a speculation. I would think that if you are hedging credit spread risk, you want to protect against the credit spread widening. So you want to profit from an increasing credit spread. So you would buy a credit spread call. As for whether it makes sense to buy a call because it costs you a premium, instead of buying a call you could sell a put in order to partially hedge.

LobsterBoy Wrote: ------------------------------------------------------- > elcfa Wrote: > -------------------------------------------------- > ----- > > PS: Paraguay, I agree with you about the credit > > spread option convention used in the CFAI book. > It > > seems to be opposite with standard industry > > convention, i.e., CFAI calls “credit spread > call” > > while one would normally call the same option a > > “credit spread put”. > > Why would use a credit spread put? I’m thinking > that normally with any long put, you make money > when the underlying decreases. So if buy a credit > spread put, it seems to me that you would make > money when the credit spread decreases. But you > would already be making money when the credit > spread decreases because the price of your bond > would increase wouldn’t it? So it’s not a hedge, > it’s a speculation. I would think that if you are > hedging credit spread risk, you want to protect > against the credit spread widening. So you want > to profit from an increasing credit spread. So > you would buy a credit spread call. > > As for whether it makes sense to buy a call > because it costs you a premium, instead of buying > a call you could sell a put in order to partially > hedge. Let’s not get into this. Memorize what the books say.

Agreed. That don’t hedge the spread risk thing then buy more when it widens makes no sense to me and seems counterintuitive to stuff taught elsewhere… …isn’t this the bond version of double down when share prices fall??? (fear of regret or loss aversion or whatever?)

If mortgage-backed securities have no default risk, why would there be a spread? It would be compensation for a risk that doesn’t exist. If sins gets it wrong, then I’m getting it wrong too. There’s no way I’m writing an answer that OAS does not capture default risk.

LobsterBoy The normal convention is you PUT the “bad” bond back to the seller when the credit spread increases (i.e., the price goes down) to get your “money back”. sins The logic is the credit spread will get back to historical average, thus buy when it is ‘out of norm’. Ref to the ‘mean reversion analysis’ tools on relative value analysis chapter, so at least the CFAI materials is consistent. seemorr Although there is ‘no’ default risk: there is still plenty of other risks: interest rate risk which you will learn how to hedge in that chapter, model risk,…

Interest rate risk is never included in a spread. It’s implicit in the risk free. Btw, people should just look up credit spread on wikipedia. I’m pretty sure OAS will be there - that’s my main source for knowledge anyways! :wink:

sins What I meant was ‘yield curve risk’ which, as I mentioned, you learn to hedge in that chapter (i.e., two bonds with/without option)