Scahill then asks, “While we are on the topic of OAS, a question that comes to mind is how the interest rate volatility assumption impacts the OAS of callable and putable bonds.” Morgan responds, “It is my understanding that as interest rate volatility declines, the OAS for callable bonds decreases while the OAS for putable bonds increases.”
Is his response to Scahill’s question regarding the impact of changes in interest rate volatility on the OAS of callable and putable bonds, Morgan is most likely:
- incorrect about callable and putable bonds.
- correct about callable bonds and incorrect about putable bonds.
- correct about putable bonds and incorrect about callable bonds.
Here since the volatility is falling and they have asked about OAS then the OAS of both bonds should rise..Getting really confused with this.Pls help.
The option-adjusted spread (OAS) depends on the interest rate volatility assumption. For a callable bond, the OAS decreases as the interest rate volatility increases, and vice versa.
A high volatility assumption generates a higher value for a call option, while the calculated value of the option-free bond remains unaffected. The calculated value of the callable bond will decrease, moving closer to the bond’s market price.
This implies that the constant spread (i.e., the OAS) added to the one-year forward rates to equate the calculated value to the market price of the callable bond will be lower
But here the question is asking us on the context of OAS so the OAS of both bonds will rise as interest rate volatility falls so both puttable and callable option will lose value if volatility falls so the answer should be based purely on OAS or straight bonds too?
Morgan’s response to Scahill is incorrect. As interest rate volatility declines, the embedded call option becomes cheaper; thus, the higher the arbitrage-free value (or model value) of the callable bond.
Callable bond value = Value of straight bond – Value of call option
A higher value for the callable bond means that a higher spread needs to be added to one-period forward rates to make the arbitrage-free bond value equal to the market price (i.e., the OAS is higher). For putable bonds as interest rate volatility declines, the value of the put option declines as does the arbitrage-free value of the putable bond.
Putable bond value = Value of straight bond + Value of put option
This implies that a lower spread needs to be added to one-period forward rates to make the arbitrage free bond value equal to the market price. Thus, in this instance, the OAS is lower.
B is incorrect. Morgan is correct about the impact on OAS for callable bonds.
C is incorrect. Morgan is correct about the impact on OAS for putable bonds.
How is morgan correct regarding the oas of callable bond ??
In it’s simplest explanation, OAS = Z Spread – Option Cost. If interest rate volatility declines, Option cost declines, therefore, OAS increases.
In case of Puttable Bond, OAS = Z Spread + Option Cost. If interest rate volatility declines, Option cost declines and therefore, OAS declines as well