I faced this question and I need your help. Can any please tell the link between OAS and Volatility with respect to putable bond? Suppose if Volatility increase (decreases) what effect would it have on OAS?
I thought OAS was the spread after removing effects from embedded options. So, holding all else equal, OAS should not be influenced by changes in volatility.
In curriculum there was a line written when there is an increase in volatility the OAS decreases for callable bonds. I was unable to understand this. Moreover what about putable bonds? Is the relation mentioned for callable bonds similar to putable bonds or different. Please help.
Increase in volatility= increased chance that call option on the callable bond goes in the money = callable bond is more likely to be called = value of that bond to me decreases b/c of the greater risk of it getting called away from me. This also decreases the OAS for the above reasons. HTH, let me know if it does not. -Andrew
Thanks Andrew. I was wondering about Putable bond. Increase in interest rate volatility increases the value of the Put Option. What it does on OAS?
You (the bondholder) own the putable bond so the put option is valuable to YOU, because you can “put” it back to the issuer if it hits a certain price/yield. So if volatility goes up, the value of the put goes up b/c its more likely to hit the putable range, therefore the OAS should go up because of this value to you. This is really important- do you understand the differences here between callable & putable bonds?
Yes I understand and thanks for helping out…
How can one put this in context of Binomial Option pricing?