Suppose that you have two bonds, identical in all respects save one: one has a call option, the other does not.
The callable bond will sell at a lower price than the option-free bond. (Ignoring, for simplicity, that the OAS isn’t added to the zero-volatility spot curve), the OAS will be higher than the Z-spread: you have to discount at higher rates to get a lower price. The difference (OAS – Z-spread) is the option cost (in basis points): it’s positive because the issuer has to pay for the call option.
Suppose that you have two bonds, identical in all respects save one: one has a put option, the other does not.
The putable bond will sell at a higher price than the option-free bond. (Ignoring, for simplicity, that the OAS isn’t added to the zero-volatility spot curve), the OAS will be lower than the Z-spread: you have to discount at lower rates to get a higher price. The difference (OAS – Z-spread) is the option cost (in basis points): it’s negative because the issuer gets paid for the put option.
If I own a callable bond, then I am at loss and issuer has some extra rights. So, if issuer has some extra rights, I as a bond holder should get something extra (Higher yield or lower Bond price). So, If I am getting a higher yield it means I am paid (by issuer) an option premium (thus lower bond price). So, it is positive. So my extra spread will be:
ZVS = OAS + option cost (extra I am getting)
In case of put this will be opposite and option cost will be negative…
@exotichedge: That’s a wonderful explanation. It makes this equation second nature to me. Can’t thank you enough for this trick.(I am calling it a trick because it sticks this whole thing into my head)
The OAS is computed by creating an interest-rate tree (e.g., a binomial tree) extending into the future: this tree starts with the spot curve, but varies the future interest rates up and down from the spot curve values. You add the same spread to each node of the tree – not to each node of the spot curve – then use those adjusted interest rates to discount the cash flows, determining at each node whether or not the option will be exercised. The amount of variation in the nodes of the tree is the volatility of the tree.
The Z-spread – the zero-volatility spread – uses the spot curve unadjusted; in essence, it is a tree with zero volatility (hence the name).
Unfortunately, when authors try to show a picture of how the Z-spread, OAS, and option cost relate to each other, they show the OAS being added to the (zero-volatility) spot curve. It’s a useful picture, but is also slightly misleading.
If we calculate the OAS for a given bond to be 85bp, then the discount rates we use in this tree (for this bond, to get today’s market price) are:
the 1-year U rate is 5.25% (= 4.40% + _ 0.85% _) and the 1-year D rate is 4.49% (= 3.64% + _ 0.85% _)
the 2-year UU rate is 6.30% (= 5.45% + _ 0.85% _), the 2-year UD rate is 5.35% (= 4.50% + _ 0.85% _), and the 2-year DD rate is 4.57% (= 3.72% + _ 0.85% _)
the 3-year UUU rate is 7.51% (= 6.66% + _ 0.85% _), the 3-year UUD rate is 6.35% (= 5.50% + _ 0.85% _), the 3-year UDD rate is 5.40% (= 4.55% + _ 0.85% _), and the 3-year DDD rate is 4.61% (= 3.76% + _ 0.85% _)
At every node we’re adding the same spread – _ 85bp _, the OAS – to the spot rate at that node.
(In fact, to calculate the OAS, we guess at the spread – maybe we try adding 50bp to each node – and see what price we get. We get a price higher than today’s market price, so we know we need to increase our discount rates. Maybe we try 100bp next, but that gives us a price lower than today’s market price. So we try something in between, maybe 75bp. And we keep adjusting our guess until we get today’s price.)