OAS is the most confusing topic in the level 2 curriculum for me. What I would like to know is the following: 1. Why does the bond with the lowest price have the highest OAS? 2. Why do callable bonds have OASZ-Spread) 3. Relative OAS Valuation (i.e., why is the OAS overvalued relative to Treasuries if the OAS=0 or OAS<0 (same when the OAS is relative to a sector benchmark) 4. I have in my notes that for callable bonds, OASZ-spread. Is this true? Why?
- Because bond prices are inversely related to interest 2. Because for callable bonds the option is owned by the issuer (i.e. it is a cost to the buyer of the bond), whereas for a putable bond the option is owned by the buyer of the bond and benefits him solely. 3. An OAS can’t be overvalued, a bond can be overvalued based on an OAS relative to some benchmark. The only time an OAS should be equal to zero is if the benchmark are other bonds of the same company, in that case if OAS>0 then the particular company bond is undervalued. 4. See answer to 2.
rellison Wrote: ------------------------------------------------------- > OAS is the most confusing topic in the level 2 > curriculum for me. > > What I would like to know is the following: > > 1. Why does the bond with the lowest price have > the highest OAS? OAS = z - option cost If OAS is high, then option cost must be low to make the math work. If option cost is low, then bond’s price is lower > 2. Why do callable bonds have OASZ-Spread) Because callable bonds are embedded options which cannot be accounted for with zspreads, you need to use OAS spread which removes the optinality effects of the callability. > 3. Relative OAS Valuation (i.e., why is the OAS > overvalued relative to Treasuries if the OAS=0 or > OAS<0 (same when the OAS is relative to a sector > benchmark) Because each bond has a required OAS i.e. the amount of basis points required to remove the effects of optionalityy and set the PV of CF equal to bond price. If the OAS is negative, zero, or even positive but less than that required OAS, the bond is overvalued because it does not fully compensate for the optionality (or volatility? not sure? can anyone help here–what is the OAS compensating for). > 4. I have in my notes that for callable bonds, > OASZ-spread. Is this true? Why? OAS = zspread - option cost
You say: “OAS = zspread minus option cost If OAS is high, then option cost must be low to make the math work. If option cost is low, then bond’s price is lower.” Why would the bond’s price be lower if the option cost is low? I would think that the bond price would be lower if the option cost is high, because to incentivise people to buy the bond with the huge call option embedded in it, the price would have to be very low to buyers.
If the bond has a “huge” (which I assume you take to mean very valuable) call option then the option cost can’t be low, it by definition is high, thereby making the bond less valuable (i.e. cost less).
OK I think I get it. I was failing to distinguish between option cost and option value. The equation says “Z-spread=OAS+option cost,” meaning that if a bond has a call option with a high value, then the price of that option is lower (as an incentive to the buyer) and the option COST is higher. Do I understand this right, adavydov7?
In Zspread=OAS+option cost all numbers are expressed in bps. So the option cost is expressed in terms of how many bps of return it costs. Hence if a bond has a valuable call option it means that the price of the option is high (i.e. it is valuable to the person long the call (the company) and a cost to the person who is short the option (the bondholder since the company can call his bond away when rates drop)), said other wise the value of the option cost in bps is higher making the OAS lower.