OAS understanding check

CFA Level II
#1

OAS is the spread we add to one year benchmark rates so calculated arb free val = price.

If interest vol increases , the call option becomes more valuable and therefore the call bond decreases. If the bond decreases we need less of a spread for the OAS to match the price?

If vol declines the call option becomes less valuable and therefore the call bond increases. If the bond increases we need more of a spread to match the OAS and price.

If the call bond increases why is it relatively cheap? I am confused on the over and under valuation.

Thanks

#2

The statements are correct but I didn’t understand your question.

#3

In the topic test answer it says

an increasing OAS it increases the relative cheapness of the bond

I am trying to understand why this is the case

#4

I believe a higher OAS would imply that it is more undervalued compared to the benchmark bond…and a smaller OAS or even negative OAS would imply that the bond is overvalued. Somebody correct me if I’m wrong.

#5

OAS increases -> the discount rate for that bond is higher -> the bond is cheaper. Simple as that.

#6

It’s important to distinguish the “relative to what”. If we are dealing with an equivalent bond, the one with the higher OAS will be cheaper because you are discounting cash flows at a higher rate (higher OAS). When you do that, the price of the bond is “cheaper”, thus a better buy.

Bond 1: 100/1.04 = 96.15

Bond 2: 100/1.0425 = 95.92 (OAS higher by 0.0025)

Assuming Bonds 1 and 2 can be considered equivalent, I’d rather buy Bond 2 and pocket that oh so sweet 23 cents.

#7

Oh yeah obviously! Didnt see it like that. OAS is the add on yield therefore higher OAS = higher overall discount rate = cheaper!

Thanks