CFAI V5, #452: However,this spread masks the fact that a portion of the nominal spread is compensation for accepting prepayment risk. CFAI V5, #460: This spread measure is superior to the nominal spread which gives no recognition to the prepayment risk. Does the nominal spread mask prepayment risk or not?
I just read this section so I hope I have it right: Nominal spreads reflect the market’s expectation of prepayment risk (along with other kinds of risk), but you can’t really tell how much of this is directly associated with prepayment risk. I wouldn’t really say it “masks” it because it’s definitely reflecting an expectation of prepayment risk, but you can’t explicitly determine how much of the spread comes from prepayment risk.
I am not sure on what the text says but prepayment risk is like having a call option on the bond. The principal can be called, or repayed at any time. There’s you need to use a spread which takes into acocunt this option. Hence the OAS is the best spread to use.
read this part last night… Was also confused by how it masks the prepayment risk… Sometimes the books can be really dumb…
In other words, the nominal spread will be larger than the OAS spread. When you buy a bond with repayment risk you will get a larger spread over say a treasury bond. And you would expect it because of the extra risk. Now if you compare two bonds, you know nothing about the prepayment risks associated and everything else seems the same with the bonds. You;d go with the one with the higher nominal spread, yes? that would seem the best value. However the nominal spread fails to adjust for this extra risk. It masks the prepayment risk. The risk-adjusted spread would be lower (ie the OAS). this allows you to compare different bonds, it takes the extra risk into account. hope this helps
chedges, all you wrote makes sense, but maybe i’m interpreting the sentences wrong (not native english speaker) but sentence 1 says: prepayment is there (it is covered), but we cannot account for it. sentence 2 says: prepayment is NOT there (since it is not recognized)… or in other words: prepayment is there, but since we cannot compute it, we pretend it’s not there.
I think you are reading it wrong. statement one says that the nominal risk is masking prepayment risk ie is not accounting for this risk, ie doesn’t take this risk into account statment two says this again, that it is not recognising the risk. same thing
> However,this spread masks the fact that a portion of the nominal spread is compensation for accepting prepayment risk. It is a little confusing. May be if it was written like this? However,this spread does not show that a portion of the nominal spread *should* compensate for accepting prepayment risk.
i think we are now on the same page. thx for clarifying chedges and dreary