Does the OAS provide compensation for credit risk?

The OAS has the credit risk embedded . It is arrived at by using a simulation ( Monte Carlo procedure ) of discounted cash flows and using prepayament rates under different conditions ( think binomial trees ) and the constraint is the price of the security through this discounting process equals the market price ( which has credit spread built in) . So indirectly the credit risk is priced into the spread.
 
i dont think so. as far as i know, it ignoes default risk for sure.
but credit risk….hm….
 
Exactly 1 year and 1 day ago, there was a long and heated discussion about OAS on this forum. I don’t think there was a consensus reached about what it measures.
http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91255488
If you ask me, I say credit risk is not priced into the spread. OAS is only measuring the effect of the embedded option. There is still credit risk present in the BOND itself. It’s just that the OAS does not have the credit risk included in its spread. Read the post and decide for yourself.
 
OAS should include credit spread just as corporate issues without embedded options have varying spreads based on credit. Think worsening credit, the wider the spread above treasuries. The OAS just differs from z spreads in that the option value is removed, and the removal of option cost makes the oas even more comparable to z spreads of bonds without embedded options. The OAS does not compensate you for the embedded option, the option cost(z minus oas) is the compensation for the embedded option.
 
Yep, the whole point of OAS is to have a measure which makes a bond with embedded options comparable to a bond without the option. So the OAS measures what the z-spread would be if the bond didn’t have any embedded options.
That spread should at the very least have credit risk and perhaps liquidity risk in it. It won’t have interest rate risk (because it’s a spread), and it won’t have risk from the option (the difference between the z-spread and the OAS spread should reflect the risks of the option).
 
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