OAS for putable bond

CFA Level II
#1

Volatility used in generating the interest rate tree is less than the true volatility, which of the following most accurately describes the impact on the value of bond B (with embedded with put option) and the estimated OAS of the bond

anwser: Value of bond is underestimated and estimated OAS of bond is too low

I dont know why estimated OAS of bond is too low :frowning: can you help

#2

When interest rate volatility is high, putable bonds have higher OAS compare to comparable callable bonds. Thus, when the volatility is too low in a interest rate tree, it underestimates putable bonds and OAS for putable bond is too low.

Think of OAS as attractiveness of a bond , the higher the OAS, the more attractive the bond.

#3

The first part of the answer is stupid; you’re using the market price of the bond to estimate OAS, so the value of the bond is estimated exactly right.

The second part is explained thus:

  • Lower volatility (in the tree) means lower high interest rates and higher low interest rates
  • Lower high interest rates means higher high bond prices
  • Higher bond prices means it’s less likely that the bond will be put
  • When the bond is put, cash flows are higher, so when it’s less likely that the bond will be put, the average cash flow will be lower
  • Lower average cash flows means lower discount rates to get to the same (i.e., today’s market) price
  • Lower discount rates means lower OAS
#4

Can I use the formulas: z spread = OAS - put premium spread to explain?

I dont know which induction is wrong

Low volatility => Value put option underestimate => Put premium spread overestimate

z spread constant => OAS overestimate (too high)