Hi i don t understand the oas definition: “it measures the spread over a variety of possible interest rate paths, including the effects of embedded options”. “It removes the effects of embedded options”… (i am re-reading the level 1 stalla material, because I remember understanding it last year…and it doesn t help so much ) I feel like i am just missing a step in the reasoning, but I spent too much time reading stuff on google and confusing me more. Could someone please give me a simple answer ? thanks
I only understand it in the simplest form, so maybe I can be useful here… The OAS equals the spread (including the option) minus the option. i.e. if the spread is 3.0 and the value of the option of 0.5, the OAS is 2.5.
yeah, OAS is a whole weird thing, just know how to calculate it, the assumptions that derive it (volatility, benchmark yield curve, etc) and general rules of thumb about it. that’s one you just gotta read about, do questions about, and do EOCs for cuz there’s a lot of meat around it. just my 2 cents.
I prefer to think about it like this: Consider a real callable bond. Suppose the market is pricing it at 102. Now consider a binomial interest rate tree that we will construct to try to value this bond. With all of our assumptions in place, using the backward induction method, we will derive some theoretical value, say 102.75. What we want to do then, is add a fixed amound of basis points to each node in our tree until our model price equals the market price. Suppose in this case it happens to be 25 basis points. Pg. 302 V.5 - “what the OAS seeks to do is remove from the nomical spread the amount that is due to the option risk.” Hope this helps.
I think the easiest way to think about it is that it’s just the Z-spread minus the cost of the option. So I think of it as a line in between the Z-Spread and the benchmark yield which breaks it into two pieces (the option cost and the OAS)
OAS is removing the value of the option to make the bond comparable to bonds with similar features that are not call/putable. A call or put option can either add or subtract value from the investment. Think in terms of an issuer, you will have to provide additional incentive to an investor if you have the right to call the bond at certain levels. That right, similar to an option, will cost the issuer money they will pay in terms of additional interest. The holder will earn extra yield for a callable or receive less for a putable bond because they now have the right to put the bond back to the issue. Since traditional bond analysis can’t deal with this structure OAS was created to compare the bonds on more relative basis.
thank you very much for your answers, that really helped !