CFA CFA Level 2 Confused with putable bond OAS vs option free bond

Confused with putable bond OAS vs option free bond

  • This topic has 17 replies, 4 voices, and was last updated Apr-17 by bceagles.
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    • Alta12
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      If putable bond z spread = -40bps and option cost = 25bps and an option free bond with the same credit rating, liquidity and maturity offered in the market of -15bps and z spread of -10bps.

      I’m confused with the negative signs. Please help @vincentt @sophie !!

    • Alta12
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      Would one purchase the option free bond or putable bond?

    • vincentt
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      I’m not too sure about the negative z-spread, maybe because it’s a putable option so they have a negative sign? (honestly i have not seen it in the syllabus)

      Also, why would you have 2 different rates for option free bond? As far as i’m aware, option free bond would have the same spread for both Z and OAS.

      Z-spread = OAS + option cost

      Sorry couldn’t help much, maybe @sophie or @diya can look at this.

    • Alta12
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      If putable bond z spread = -40bps and option cost = 25bps and an option free bond with the same credit rating, liquidity and maturity offered in the market at a nominal spread of -15bps and z spread of -10bps.

    • Alta12
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      It was in the elan mock. i fixed the typo. The answer is saying that the putable bond is offering too low a yield (-40bps+25bps=-15bps) vs the option free bond of -10bps.

    • vincentt
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      @alta12 well if z spread is indeed -40bps and option cost is 25bps then OAS should be —> – 40bps – 25bps = -65bps
      moving positive option cost over to the left side should make it negative, unless the typo you are referring to is actually -25bps to begin with then you are right on the (-40bps + 25bps)

    • Alta12
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      @vincentt the answer is saying the OAS for putable bond is -15bps (-40bps+25bps) vs. the option free bond of -10bps. What I don’t get is that wouldn’t a putable bond offer a lower yield than an option free bond as the buyer would pay more for the put option in the bond? I don’t get how we can conclude -15bps OAS for a putable bond is more expensive than an option free bond of -10bps based on the z spread.

    • vincentt
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      OAS does not include option cost as it’s the “option removed spread”, so you don’t even have to talk about ‘put should be more expensive than option free’.

      So by comparing a AAA corporate bond against a benchmark of say treasury bond, your corp bond should have a positive OAS and must also be more than the required rate, otherwise it would be considered overvalued.

      Now back to your example, your comparable Z spread for a option free bond = -10bps
      Z spread = OAS + option cost
      – 10 bps = -10bps + 0 (since it’s option free)

      The OAS for the putable bond = -15 bps (OAS is the option removed spread as mentioned above hence it can be compared with bonds without options)

      -15bps < -10bps Therefore, the spread (excluding the option cost) on the putable bond is less than the option free bond with similar credit rating, liquidity and maturity.

    • Alta12
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      Got it! Thanks @vincentt I think the -ve sign confused me. Cheers!

    • vincentt
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      no prob @alta12 !

    • Alta12
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      @vincentt how is your study going? Completed the CFAI mock yet?

    • vincentt
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      i did CFAI’s AM yesterday, got distracted soooo badly.. didn’t manage to debrief it entirely. But I’ll be working on PM today, how about you?

    • Alta12
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      I’ve gone back to revision. Will hit the CFA mock on Monday.

    • Sophie Macon
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      The LAST PUSH GUYS, YOU CAN DO IT!!

    • Alta12
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      FRA revision has taken me a whole day >:P

    • bceagles
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      Dont forget to memorize/understand the Relative OAS Valuation table that outlines the 3 benchmarks (Treasury, Sector, and Issuer-Specific) and remember that you always want to choose the bond with the highest OAS and lowest option cost. Doing CFA mock tomorrow. Interested to see the score relative to my Schweser exam scores.

    • Alta12
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      Thanks @bceagles! Let me know how you go with the CFA mock. I’m doing mine tomorrow too.

    • bceagles
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      73% on both the AM and PM sections (mimicked the actual exam as much as possible). I found the PM to be much harder (esp. the first FRA section). I plan on spending M-W reviewing my weak areas (along with daily formula/note card review) and Th/Fri reviewing FRA/Equity/Ethics. Hoping to log 30 hours of study! Best of luck to you.

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