Can someone intuitively explain the following to me:
Z-spread represents the all in risk of a bond: Liquidity risk, Credit risk, and the risk of any embedded options (e.g call risk, put risk)
OAS is the Z-spread with the option risk factored out. In other words, its the spread of the bond if the embedded option were ignored. In this way, it represents the Liquidity and Credit risk of the bond only.
With the above in mind, what happens to the OAS when yield volatility decreases?
Based on my understanding, nothing. Yield volatility effects the value of the option only, which is not included in the OAS. Why is Kaplan and CFAI telling me I am wrong?
Full disclosure: I’m Still studying for my first try at level one, but maybe I can help you here.. My understanding is that OAS includes the option rather than excluding it as you mentioned above. It’s taking into account the risk that the option is exercised, like prepayment risk in MBS or call risk for a bond issued with a call option that could increase interest rate risk for instance. It could also narrow the spread if it was an option like a put option for the purchaser of the bond. A put option makes a bond less risky to a lender, intuitively, lower risk = lower spread.
For or a very broken down explanation of the above, see: (second post)
I’m not sure I KNOW the answer to the volatility question, but I’d imagine when yield volatility decreases, then the spreads narrow, an OAS includes interest rate risk and all others that would cause a standard spread to narrow, so when one component of a larger pie, decreases, I would imagine the large pie (oas) decreases as well. What I might also consider is that the YTM off the bond may cause the call price to be higher than the FMV of the bond, or prevailing interest rates aren’t low enough for borrowers to prepay. See the last paragraph in the article below.
When schweser explanations don’t make sense for me, I’ve been finding success with investopedia.
Hopefully somebody further on can validate this, but I think the above is accurate. Just trying to help out here, good luck.
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