OAS and option risk

CFA Level II
#1

It looks like OAS for bonds do not reflect option risk, but OAS for MBS/ABS do. Is this true? Thanks in advance!

#2

Bonds with callable options do reflect option risk and MBS/OAS too. Plain vanilla bonds do not reflect option risk and hence Z-spread is used. (not sure)

#3

So when do we use Nominal Spread, if at all?

#4

I look over the relative value analysis in SchweserNotes and it looks like under all three types of benchmark (Treasury, Sector and Issuer specific), OAS does not reflect option risk. This seems to apply to bonds with and without options. (For bonds without options, Z-spread = OAS since option cost is 0, so it’s a non-issue.) Then in the MBS and CMO section in Secret Sauce, it says OAS reflects option risk (assuming we are using Treasury spot rates in Monte Carlo simulation). This doesn’t sound right because OAS is adjusted for option cost (Z-spread - option cost = OAS). Anyone has a thought on this? Thanks in advance!

#5

For MBS and CMO valuation, nominal spread is not used because it masks the portion of spread accounted for prepayment risk. Use OAS from Monte Carlo models. For bonds without options, nominal spread can still be used if the yield curve is flat. For bonds with options, use OAS from binomial models.

#6

swaptiongamma Wrote: ------------------------------------------------------- > So when do we use Nominal Spread, if at all? In Level I…

#7

Guys I have a question along the sidelines of this subject, if someone could clarify it for me it would be greatly appreciated: Schweser Notes, book 5, page 98, LOS55.g summary paragraph: “…any corporate bond with an OAS less than or equal to 0 is overvalued relative to the benchmark, because it must have more credit risk, and most likely more liquidity risk, than the benchmark.” 1) If OAS is negative or equal to zero, doesn’t it mean that the credit spread and liquidty spread are both negative or zero?? if so, then how could it be possibly having more credit risk than the benchmark?? 2) when we say “overvalued” and “undervalued”, is it relative to the market price of the benchmark? 3)If so, then are the fair values of the bond in question and that of the benchmark equal? Thanks a lot for the help…

#8

norminal spread=Return - trasuary rate OAS=Z spread less option cost(call) or add option cost (put) OAS does not reflect option risk but credit risk, volatility e.tc.

#9
  1. Because the benchmark spread can be negative too. 2) Yes, in relative value analysis, you are comparing OAS to a particular benchmark spread. 3) Only if you are using an issuer benchmark and OAS = 0.
#10

I just asked for clarification from Dr. Levkin about OAS and option risk. OAS does not reflect option risk for bonds (because the option has been removed when calculating OAS). Unfortunately, I can’t get a straight answer from Levkin regarding whether or not OAS for MBS/ABS would reflect option risk or not. (Secret Sauce says so, but the notes is silent on this topic.)

#11

Interesting, anyone figure this out?

#12

z spread = oas + option cost compare oas to nominal spread to see if bond is rich or cheap. too tired right now to explain more. tight spread = rich , wide spread = cheap

#13

I got a reply from Schweser today, saying that they would rephrase that passage in Secret Sauce about OAS (for MBS/ABS) reflects option risk in later revision. So I don’t really know where Schweser stands on this issue. If I must pick on the exam, I would just say OAS doesn’t reflect option risk, regardless of it is for bonds or MBS/ABS. This way I know at least I am right 50% of the time. XD

#14

so anyone on this forum can explain why OAS is used for i.e. home equity loan ABS, who has prepayment risk and therefor an option? i thought OAS is option-free?? i really dont get this!! starting to go nuts!!!

#15

I got pretty annoyed too when I still couldn’t get a straight answer out of such a simple question from Schweser. (I thought my question is pretty simple too: does OAS for MBS/ABS reflect option risk?) We have roughly two more weeks to go. I would probably leave this problem as is and move on to reviewing other sections.

#16

For a security with an embedded option (such as an MBS) the OAS is the spread the adjusts out the bps cost of the embedded option thereby making the OAS spread of such a security comparable to the Zspread of securities without embedded options. I.e. the OAS is ALWAYS the spread that excludes option risk, it is a spread that only compensates for liquidity and credit risk, not prepayment risk. Does that help?

#17

That’s what I thought (and the answer I will be giving on the exam) too. This question was raised because Secret Sauce says otherwise (P.158).

#18

I don’t trust Schweser, I treat as, at best, a tertiary reference for these sort of simple mistakes. Glad I could help.

#19

eltia, i belive you are right that oas has removed option risk in both bonds and MBS/ABS. I think the issue here is schweser’s poor wording in secret sauce page 158. when they say “pas reflects option risk” i think they mean that oas takes it into account and removes it (i.e. reflects/takes it into consideration). sounds like a stretch i know but it either means this or its an error because oas is definitely the spread with option cost removed.

#20

I believe so too. Otherwise how can OAS reflects something that has already been removed. XD