Question on Option Adjusted Spread...

CFA Level III
#1

Hi, this is my first post i suppose…

Spread = option cost + OAS.

Option cost depends on the volatility of the interest rate. More volatility => option cost increases. Less volatility => option cost decreases.

What i dont understand is: does the OAS increase and decrease together with the option cost?

That is, when volatility increases, the overall spread will be higher because BOTH the option cost and the OAS are larger?

#2

Spread after adjusting for option (OAS)

When volatility increases option value increases. So larger value is deducted (due to high value of option cost) hence OAS decreases

#3

Z-spread or static spread is not constant. When the volatility increases, the OAS could increase/decrease since it reflects the credit risk, liquidity risk and etc. – please correct me if I’m wrong. OAS does not reflect the default risk.

#4

I think for a callable bond higher volatility lowers the option adjusted spread as rahuls pointed out.

But for a putable bond , higher volatilty increases the option adjusted spread.

In other words the option holder ( i.e. buyer ) is affected worse than the option provider ( i.e. seller ) , when volatility rises

#5

Jana, can you point out where I can find it in the curriculum? Thanks.

By the way, OAS depends on the model used. In other words, it may reflect the model risk?

#6

FYI.

“If interest rate volatility increases, and nothing else changes (in particular, the price of the MBS stays the same ), then OAS will decline.”

http://www.wilmott.com/messageview.cfm?catid=8&threadid=68056

#7

Found this on page 173 of Reading 23:

“because the OAS adjusts to compensate the investor for selling the prepayment option to the homeowner, OAS tends to widen when the expected volatility increases and narrow when expected volatility decreases”.

It seems, OAS does indeed increase “to compensate” for the value of the embedded option…

#8

Sorry I was remembering OAS from L II days. Putable bonds OAS is not covered in L III.

#9

V4, P172: For MBS, “OAS tends to widen when expected volatility increases…”

But this is not the case for Callable Bond that we have been discussed. I couldn’t understand why.

#10

Yield on MBS = yield on T sec + Spread.

Here Spread is sum of option cost = cost of bearing prepayment risk + OAS - compensation for bearing the remaining risk (i.e. spread risk, volatility risk, model risk, interest rate risk)

1)Now Spread risk - usually not hedged coz that is the whole purpose of investing in MBS.

  1. Int rate risk = hedged by selling T notes/futures. Now investor earns T bill + Spread (#1 mentions it is not usually hedged)

  2. Model risk - can not hedge.

  3. Prepayment risk - now what I understood is when int rate increase, prepayment period extends (i.e. like in a floating mortgage loan - if interest rate increases & you don’t wish to change ur monthly mortagage cost (EMI) your tenor increases in amortization schedule). When interest rate decreases, prepayment period shortens.

This means that mortgage duration is increasing (i guess due to increase in prepayment period) when interest rate increases & mortgage duration decreases when int rate decreases. This is against our desire. I mean we would like duration to increase when int rate goes down (to make it more sensitive to int rate to capture larger gains) & duration to decrease when int rate goes up (to loose less). To hedge we need to buy options or hedge dynamically. Hedging dynamically will require us to to increase duration (buy futures) when rates decline & decrease duration (selling futures when int rate increase. )

  1. Volatility risk - now option has feature of increase with increase in volatility & vice versa We have sold prepay option. I think now when volatility increases, option cost increases. Since we are short on option, effect to us is opposite. So OAS tends to widen with increase in volatility. We can hedge volatility again by buying options or hedging dynamically.

Let me know if i am wrong somewhere.

#11

Found this on page 172 of Reading 26

I think the OAS tends to widen with ragard to in crease in EXPECTED volatility.

The EXPECTED volatility and the REALIZED volatility are tow different things.

My point is: the manager developed his own expected volatility(which refers to the implied volatility),and compares it with the realized volatility.If the former exceeds the latter,the manager hedges dynamicly,or purchases options in the opposite situation.

#12

Found this on page 172 of Reading 26

I think the OAS tends to widen with ragard to in crease in EXPECTED volatility.

The EXPECTED volatility and the REALIZED volatility are tow different things.

My point is: the manager developed his own expected volatility(which refers to the implied volatility),and compares it with the realized volatility.If the former exceeds the latter,the manager hedges dynamicly,or purchases options in the opposite situation.

#13

I think implied volatilty is which you infer based on the current cost of option. Now manager forms an expectation of the future realized volatiltiy (actual over the term of option). If he thinks implied volatility is more (means option price is incorporating higher volatility in future & trading at high cost) than future realized volatility, he hedges dynamically (buying/shorting T notes/futures)

#14

Am i understanding this correctly ?:

  1. Investor of MBS is short an option in the form of the homeowners’ right to prepay the mortgages.
  2. Since this optionalty is a benefit to the homeowner and a detriment to the investor when interest volatility is high,the investor must be compensated via a wider OAS.
  3. Since the OAS is added to the spot curve to discount MBS cashflows, a higher OAS means a lower price for the investor.
  4. Hence if an investor is presented with two otherwise identical MBS products he/she would prefer the one with a higher OAS, as this implies [a] Lower price,[b]Higher yield.

thx for any help

#15

Good testing points. Ultrablue, before AF speeds up its site, can you please keep one post if the two are the same.:wink:

#16

Still confused with the following 3 concepts:

1.expected volatility;

2.implied volatility;

3.realized volatility.

Found this on page 172 of Reading 26

As the reading said: in case the implied volatility is smaller than the realized volatility, the manager purchases options to hedge.

----What does “purchase option” refer to,to be specific?

any help will be very much appreciated.

#17

Still confused with the following 3 concepts:

1.expected volatility;

2.implied volatility;

3.realized volatility.

Found this on page 172 of Reading 26

As the reading said: in case the implied volatility is smaller than the realized volatility, the manager purchases options to hedge.

----What does “purchase option” refer to,to be specific?

any help will be very much appreciated.

#18

I think it’s to buy interest rate options(floor), treasury futures options, or the like.

#19

I think

Expected volatility = Market’s expectation about volatility

Implied volatility = volatility implied by the current option cost. I think black scholes model can help us derive this.

Realized volatiltiy = actual realized volatility during the term of option.

Now if implied volatility is higher than the manager thinks actual realized volatility would be in the future - can hedge thru futures.

Why not options? I think due to high implied volatility reflecting in the current cost of option but it is expected to come down (realized volatility would be lower) one way to gain now is go short on the option trading at a higher price & buy back later. BUT since you are already short on the option embedded in MBS, you can only buy option to hedge it. You would hedge dynamically here (by shorting future)