The CFA text says the higher the interest rate volatility, the LOWER the OAS for callable bonds and the HIGHER the OAS for putable bonds. Intuitively, it seems like it should be the opposite. If interest rate volatility is high, that means the call option is more valuable, so it’s an advantage to issuer and disadv. to bondholder. So shouldn’t the OAS be HIGHER since the yield must be higher to compensate for the disadv to bondholder? I know I’m confusing something here… just doesn’t make sense to me. Can someone please explain. Thanks in advance!
Value of callable bond= Value of option free bond - call option. if it isvolatile, value of option increases, and value of callable bond decreases as it would require additional yield to compensate for this. Value of putable bond= value of option free bond + put option. If it is volatitle, value of the option increases, and thus value of the putable bond increases. hope it helps.
Still kinda confused on this one myself. This would make sense though if you hold the yield on a callable bond steady but increase interest rate volatility. Since Z-Spread - OAS = Option Cost if Z-spread is constant but option cost increases, OAS will decrease. Option cost would increase on a callable bond if interest rate volatility increased. Just a guess… anyone?
I will try… Z spread is misleading high because it ignores the negative effect the call will have on price. OAS yield is low in a callable bond…because there is a cap on the price. The bond can rise upto the call price, you will not get the upside that you would have with a straight bond. This means lower gain, lower yield. So when a bond has a cap on price, the investor gets a lower yield than a straight bond. So the OAS takes into account the negative effects of a call option, and it is lower than Z spread, which ignores the call option. For a Put, the investor gets a higher yield. Because the OAS takes into account the positive effect of the put option. The Z spread is lower because it ignores the put option, the Xtra benefit to the bondholder. The difference between the Z spread and the OAS is the value of the option.
Z-OAS = option value rearrange it, you get OAS = Z - option value. the higher the interest rate volatility, the greater the option value. but note that call option value is positive, Z - a greater positive value, you get a smaller OAS. while put option value is negative, Z - a greater negative value, you get a larger OAS.