There are differences in callables/MBS, mainly due to further uncertainty with an MBS over what happens when the option is called: With a callable bond, the holder of the bond receives the call price, a fixed and known price (and usually above par, given the call price is above par you are generally compensated for the loss of future coupons). With an MBS (depending on the payout structure as well as past payments/remaining payments) it can be unclear just how much you will receive when the bond is ‘called’ (ie when pre payments increase) as scheduled principal/interest may or may not be paid as per the schedule.
In fact the more I think about it the more I think the generalisation is invalid. Going back to the real-world stuff (somewhere in my head), OAS isn’t a well calibrated number, you could go across several institutions and ask them to calc OAS on a single MBS bond and they will come up with very different numbers, because it is completely model dependant, and as such moves in the OAS will be somewhat dependant on not only the model in use but also the specific bond being modelled. It’s certainly possible that there is a general trend of increasing OAS with increasing vol’s, but this trend would have been observed from general market trends rather than down to the maths of it all. (It’s much more clear cut with callable bonds though)
MBS is also path dependent…and more model risk[related to prepayment speed] may be involved in OAS calculation for MBS…Options in callable bond is a single call, while the embedded options in MBS are much more complex.
Thinking about it, the major difference between a callable bond and a MBS is due to the amortizing nature of the MBS (i.e. lower duration). More reinvestment risk equals must be compensated by higher spreads. For the spread to widen, the spread over treasuries must widen by more than the offsetting (or at least partially offsetting) increase in the option cost as mik82 pointed out somewhere up there. No formula here… Officially confused. thanks
back to cfai text, I think key words are: “future interest rate volatility is expected”…“OAS tends to…” the effect of vol change interpreted by formula oas = z-spread - opt price (and explained in level 2) is considering current implied/market volatility and its change and given fixed z-spread… in that case if market vol increases, oas goes down and I have this feeling that with higher expected volatility, any spread would widen (but this goes beyond the cfa program)
Hi, guys. The key question is: When the [expected] volatility increases, z-spread usually changes. It’s not a constant. z-spread is calculated by assuming zero volatility; but it doesn’t mean by that z-spread doesn’t change when the volatility changes. – I’m not playing the words…just try to hold it, and not to fall apart.
Agreed, it’s beyond L3 scope.
I found out we may be all right.
Two arguments: 1) Assume z-spread is fixed: this could happen when running the valuation model to shock the volatility. Keeping z-spread constant, OAS increases when vol increases. 2) Z-spread changes over time. When the volatility changes, the bond prices changes, so do z-spread and OAS.
Althought we shouldn’t leave anything out, I think this is a small detail. So no worries.