I know z spread has credit + liquidity + option risk. But what does it mean to say OAS only has credit + liquidity risk? When it says option adjusted - does that mean it doesn’t take option risk into account, or it does take option risk into account?
WITHOUT option. Think Option Removed Spread = Option Adjusted Spread
That makes sense - but then why are we using the OAS when working with option bonds if the OAS is the option removed spread? Sorry for the basic question
So that bonds with options are comparable to straight bonds?
OAS is a spread that includes credit risk and liquidity. By using an OAS, you have removed the option value.
For example, Z Spread = OAS + Option Cost for Callable Bond. The OAS = Z-Spread minus Option Cost
For a Putable Bond, Z Spread = OAS - Option Cost. The OAS = Z-Spread + Option Cost.
Just think of it as removing the option value from the bond.