Can someone going through the Fixed Income section please explain the Zero Volatility spread and option-adjusted spread in level 3 context?
Schweser isn’t quite clear… and kind of just rushes through this…
Zspread - spread added to the spot curve to equate cash flows and price (can someone explain this)
Option adjusted spread = SPread accounting for embedded options.
I remember for Level 1 or 2, we were looking at things like if the OAS > Z-spread… then its a call option or something like that. None of it seems to be relevant for this level…
OAS used in bonds with optiond. It basically remove the option from the bond and compare it’s yield to treasury. Zspread is the IRR that will make the bond of corpora’re price equal to the on the run treasury.
Option-adjusted spread (OAS), the current spread over the benchmark yield minus that component of the spread that is attributable to any embedded optionality in the instrument. Many US practitioners prefer to value investment-grade credit securities in terms of option-adjusted spreads (OAS) so they can be more easily compared to the volatility (“vol”) sectors (mortgage-backed securities and US agencies). But given the rapid reduction of credit structures with embedded options since 1990 (see structural discussion above), the use of OAS in primary and secondary pricing has diminished within the investment-grade credit asset class. Moreover, the standard one-factor binomial models do not account for credit spread volatility. Given the exclusion of default risk in OAS option-valuation models, OAS valuation has seen only limited extension into the higher-risk markets of the quasi-equity, high-yield corporate, and EMG-debt asset classes.
Static spread or zero-volatility spread, defined as the constant spread above the Treasury spot curve that equates the calculated price of the security to the market price.
For OAS, consider a bond with an embedded call option. The yield (and z-spread) will be higher than an equivilent bond because investors subtract the value of the option from the price. If the Z-spreads between the bond with the call and without were compared, it would look like the bond with embedded call is undervalued. The OAS accounts, as per below example:
If you discount the cash flows of a risky bond using Treasury spot rates, the value you get is higher than the market price: you’re discounting at interest rates that are too low. So, you add a spread to each spot rate, and fiddle with it until the value equals the market price; the resulting spread is the z-spread.
If you discount the cash flows of a risky bond using Treasury rates in a binomial interest rate tree (including any effects of embedded options), the value you get is higher than the market price: you’re discounting at interest rates that are too low. So, you add a spread to the (forward) rate at each node, and fiddle with it until the value equals the market price; the resulting spread is the OAS.
The option value is z-spread − OAS; if this number is positive, the option favors the issuer (so it’s a call option or a prepayment option, for example); if this number is negative, the option favors the bondholder (so it’s a put option or a conversion option, for example).
You’re correct: at Level III, this last bit isn’t likely to be relevant.
I wrote in my notes that OAS is of limited use when you want to analyze speculative grade bonds, 'cause in OAS default risk is excluded from the calculation.
What is wrong or right about my note? I am confused now
The OAS is the spread for the bond without the option (“option-adjusted” means “option-removed”). Nothing else about the (straight, underlying) bond has changed: its default risk, interest rate risk, currency risk, event risk, credit risk, and so on are all the same.
