OAS Spread

CFA Level I
#1

I have like 4 topics where I have tried to teach myself the logic, but I still struggle. It is keeping me up at night! Can someone please put OAS spread in laymans terms? This is one of them… I understand Zspread - the amount that you must add to each rate on the treasury spot yield curve for a risky bond. I realize I can just go look it up in Schweser, but maybe someone can spark something in my brain so I can hammer this concept down. Thank for any assistance…

#2

OAS is the spread the bond would be trading at which (relative to whatever benchmark you are using) if the bond has no optionality. OAS = Total spread - (spread due to optionality) OAS is used to compare similiary products that have different option characteristics. All else equal, the higher the OAS, the lower the interest-rate risk.

#3

Please correct me if I am wrong A call option would then decrease the OAS Spread (since removing the call would be beneficial for the bondholder). A put option would then increase the OAS Spread (since removing the put would be beneficial for the issuer). Or is that backwards!?

#4

You have it correct. But if u look at the nominal spread instead of the OAS, it will actually say that the Call bond is worth more, it will actually overstate the price of the bond, hence the reason to use OAS

#5

ok so is it safe to say start with the nominal spread. If the OAS is smaller, then you have a callable bond. If the OAS is larger than you have a putable bond!? Ok so now help me place the Z spread in there, and I think I will be able to sleep more soundly tonight haha

#6

Yes for the first question. The Z spread and nominal spread will be very similiar if there is no prepayment risk, (bullet bond). If there is, then you should use Z-Spread. If the bond has options than use the OAS. Option Cost = Z spread - OAS (remember this equation and variations of it!) Zspread = OAS + Option cost etc etc Also know that with OAS it is based on a model. So depending on the model that is being used, it can have different spreads. I know I saw a test question asking something like which spread is suceptible to model risk or something like that. Just know that OAS is based on a model, might be a question.