Sharon Rogner, CFA is evaluating three bonds for inclusion in fixed income portfolio for one of her pension fund clients. All three bonds have a coupon rate of 3%, maturity of five years and are generally identical in every respect except that bond A is an option-free bond, bond B is callable in two years and bond C is putable in two years. Rogner computes the OAS of bond A to be 50bps using a binomial tree with an assumed interest rate volatility of 15%.

If Rogner revises her estimate of interest rate volatility to 10%, the computed OAS of Bond B would *most likely* be:

A) lower than 50bps.

B) equal to 50bps.

C) higher than 50bps.

Answer C.

Explanation - The OAS of the three bonds should be same as they are given to be identical bonds except for the embedded options (OAS is after removing the option feature and hence would not be affected by embedded options). Hence the OAS of bond B would be 50 bps absent any changes in assumed level of volatility.

When the assumed level of volatility in the tree is decreased, the value of the call option would decrease and the computed value of the callable bond would increase. The constant spread now needed to force the computed value to be equal to the market price is therefore higher than before. Hence a decrease in the volatility estimate increases the computed OAS for a callable bond.

Can someone please explain this? I am not getting it. Thanks in advance.