Why a bond with a larger OAS is considered underpriced vs an identicable bond with a lower OAS?
What is lthe logic behind this statement?
take away the option from the bond, and you are left with a plain vanilla bond.
so a bond with a large spread to AAA will be cheaper.
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Think of it this way, a constant OAS is added to all the spot rates across the curve to make a bond’s value =
market price. These new spot rates are used to discount all the cash flows to compute price. Higher the new spot rates, the lower the bond price (i.e., it would be undervalued). OAS and bond prices work inversely.
Hope this helps.
Thanks a lot guys! I got it!
Can anyone give an example why/how bonds would have a mispricing on OAS.
I really can’t figure out, why?
I spent six years at PIMCO developing prepayment models for mortgage-backed securities.
Everyone has their own prepayment model; their OAS is calculated based on their model.
If the model is flawed, the OAS is flawed.
CFAI would probably say market segmentation.
i.e. a pension fund is not interested in a 30yr callable bond.
probably you’ll get also get mispricing when the option interferes with a related strategy (rolling down the curve) and mismatched supply/demand.
there is also more general put option mispricing for stock indexes. i don’t know if it effects bonds.