Hi I am curious about why OAS is used and not Z spread. Why should prepayment risk (as an option) be taken out and only OAS be used. Even that is a risk that has to be considered for pricing. So why is a security with higher OAS considered a cheaper security rather than a security with higher z spread. Kind of confusing. Can some one help me understand this. thanks
answer to the 2nd part: spread increases - this is add on to the base yield curve (treasury spot curve). so your yield at which you are going to “calculate” the PV of cash flows is increasing. once that happens - your price will drop… so it is a cheaper security. Answer to the first part: Why is OAS used and not Z-spread? Prepayment option is a “option” available on the MBS/ABS. Once there is an option - the OAS is the only one to be used… (you are adjusting for the option (removing the Option)). Z-spread is for option free bonds.