Hi, Raw yield spreads are classically referred to as nominal; yield spreads. After the value of the embedded option is “removed” it is called as Option Adjusted Spread. The CFA notes have an example of the OAS spread(63 bp)
I buy a bond with prepayment risk embedded in the bond for a yield of 8%. If there was no prepayment risk I would be getting only 7% because I don’t like prepayment risk as a bond holder. If Treasuries of similar maturity are trading at 6.5%, the bond has a nominal spread of 150 bp and an OAS of 50 bp.
Thanx JDV…that makes it so much clearer…was confusing nominal spread with yield itself. So if I buy a bond with PP risk then my yield should be (based on previous example), 6.5%(treasury) + 150 bp(nominal)+50 bp(OAS)= 8.5 bp. Right?
No because nominal spread = OAS + cost of option so OAS is included in nominal spread.