OAS and Z-spread

Thammer · May 25, 2017, 4:52am

Hi,

What are the difference between OAS and Z-Spread?

To me they seam to be the same: “A spread added to the risk free rates to arrive at current market price for a risky bond”.

Mercutio · May 25, 2017, 9:49am

My understanding: The z-spread ignores options embedded in the bond (z for zero volatility) that will change the market value of the bond and thus lead to a different YTM since you just use the MV without correcting for the difference in value that comes from the option

timothy1949 · May 25, 2017, 10:29am

Z spread means zero vol, and when volality is zero options are worthless = Z spread not suitable for bonds with options

OAS means option adjusted spread and since it is adjusted for options so it can be used to value and compare bonds with options

Thammer · May 25, 2017, 11:51am

Thanks. That clears it up!

S2000magician · May 25, 2017, 4:07pm

The z-spread doesn’t ignore options embedded in the bond; you can adjust the cash flows as appropriate should the option be exercised.

What it doesn’t do (that the OAS methodology does) is offer multiple interest rate scenarios to allow you to calculate an expected value for any options; as you say, it has zero volatility, so the future interest rates are deterministic. The value you get for an embedded option is the value only if interest rates evolve according today’s (fixed) yield curve.

Thammer · May 25, 2017, 4:41pm

S2000magician:

Mercutio:

My understanding: The z-spread ignores options embedded in the bond (z for zero volatility) that will change the market value of the bond and thus lead to a different YTM since you just use the MV without correcting for the difference in value that comes from the option

The z-spread doesn’t ignore options embedded in the bond ; you can adjust the cash flows as appropriate should the option be exercised.

What it doesn’t do (that the OAS methodology does) is offer multiple interest rate scenarios to allow you to calculate an expected value for any options; as you say, it has zero volatility, so the future interest rates are deterministic. The value you get for an embedded option is the value only if interest rates evolve according today’s (fixed) yield curve.

Can the z-spread be used for bonds with embedded options?

S2000magician · May 25, 2017, 4:52pm

Unfortunately, this is completely wrong.

If you have an upward sloping yield curve, for example, a put option may come into the money with no volatility.

S2000magician · May 25, 2017, 4:56pm

Thammer:

S2000magician:

Mercutio:

My understanding: The z-spread ignores options embedded in the bond (z for zero volatility) that will change the market value of the bond and thus lead to a different YTM since you just use the MV without correcting for the difference in value that comes from the option

The z-spread doesn’t ignore options embedded in the bond ; you can adjust the cash flows as appropriate should the option be exercised.

What it doesn’t do (that the OAS methodology does) is offer multiple interest rate scenarios to allow you to calculate an expected value for any options; as you say, it has zero volatility, so the future interest rates are deterministic. The value you get for an embedded option is the value only if interest rates evolve according today’s (fixed) yield curve.

Can the z-spread be used for bonds with embedded options?

Yes.

Recall the typical picture relating the z-spread, OAS, and option value. The z-spread (if you assume that the option isn’t exercised) is the spread for the bond with the option, the OAS is the spread for the bond without the option, and the difference is the option value.

You simply have to bear in mind what the z-spread means in that situation.