When the issuer has the option(callable bond),the higher the interest rate volatility assumed lower the option adjusted spread,in the case of a putable bond the higher the interest rate volatility assumed,higher the OAS. Please Explain.
if you are a holder of a putable bond you want the interest rate volatility high so that prices will be volatile. Why? Because the chances are higher that you can put the bond to the issuer at a high price. If you do this your chances of making a profit are higher there the OAS is higher. I think…
Z-Spread - OAS = Option Cost The higher the interest rate volatility, the higher the probability an issuer of callable bond will redeem the bond. This means that as an issuer, it will cost him more to issue callable bond. This cost is the option cost. Option Cost > 0 for callable bond Option Cost < 0 for putable bond
Attempting to explain this. 1. A callable bond is beneficial to Bond Issuer and not to the Bond Holder. So, Bond Holder asks for additional yield if there is a Callable Option embedded in the bond. Meaning yield spread for a callable bond is typically higher. Now, OAS is the yield spread of that bond when embedded option is REMOVED from it. If you remove Call option from a callable bond, its yield should decrease substantially and thus its yield spread should reduce. 2. Similarly, yield of a Puttable bond is lower than a regular bond, because a puttable bond is beneficial to bond holder. So, when you remove the effect of Put Option from that bond, its yield should increase and so would its yield spread. So, under volatile conditions, when there are lot of chances of Call and Put options to be exercised, cost of these options go up and respective OAS for Callable Bond gets LOWER and OAS for Puttable Bond gets HIGHER. Did it help?
revenant Wrote: ------------------------------------------------------- > Z-Spread - OAS = Option Cost > > The higher the interest rate volatility, the > higher the probability an issuer of callable bond > will redeem the bond. This means that as an > issuer, it will cost him more to issue callable > bond. This cost is the option cost. > > Option Cost > 0 for callable bond > Option Cost < 0 for putable bond +1 1. Z-Spread - OAS = Cost of Call Option When volatility is high, cost of Call Option goes UP and keeping Z-Spread the same, OAS for Callable Bond has to REDUCE to balance it. 2. OAS - Z-Spread = Cost of Put Option When volatility is high, cost of Put Option goes UP and keeping Z-Spread the same, OAS for Puttable Bond must INCREASE to balance the equation.