There is just one thing in the curriculum I do not seem to grasp:
OAS is the constant spread added to the (forward) rates in order to arrive at the market price. However, if I take a look at the valuation framework in Reading 45 we are incorporating the effects of the option - so how is this the spread WITHOUT an option? My undestanding is the exact opposite: Z-spread does not include option value and OAS does. Can someone shed some light on this please because I do not seem to understand this important topic.
The short answer to your question is that while the binomial tree explicitly includes the value of the option, the market price of the bond _ also _ includes the value of the option; the two cancel, and you’re left with a spread appropriate to an option-free bond.
I hadn’t seen that one yet, as it looks like you recently posted it earlier in the month. I must say, it may be one of your best topic posts to your blog yet, which is a tall order given the high quality of your previous contributions. Absolutely loved it, and thanks.
Question, will you be teaching the Wiley Fixed Income class on the 9th? If so, I won’t be skipping that one. I really want to slam dunk Fixed Income this year.
Thanks for your kind words. I just added a bit at the end about the rule for when an option will be exercised. It’s another bit that is rarely mentioned explicitly, but it’s quite important when considering the accuracy of OAS calculations.
I’m usually studying Saturday mornings, so I watch some of the lesson archives during random free time (free time? lol … right), but I’m going to try to get that one live. See (hear?) you then (probably).