how do volatility assumptions affect OAS?

blademaster3090 wrote:hey s2000, could you please clarify if what i said earlier is right?
ie:
OAS is not affected by volatility of interest rates, since the option is the part that is affected by interest rate volatility and OAS is the part of Z spread that has the option effect removed.
an increase in interest rate volatility increases the VALUE of both the call option and put option. HOWEVER,
an increase in the value of a call option would make the bond less valuable and hence would lead to a lower price in a callable bond.
an increase in the value of a put option would make the bond more valuable and hence would lead to a HIGHER price in a putable bond.
to summarize, increase in interest rate volatility:
does not affect and option-free bond.
decreases the price of a callable bond.
increases the price of a putable bond.
there’s just so much conflicting info going on, i just want to know if my way of thinking is right.thanks a ton.
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The true OAS is not affected by a change in the volatility of interest rates. The calculated OAS is affected by a change in the assumption of the volatility of interest rates.
What you wrote is correct.
 
I’m certain S2000 is correct, but for exam day, what are people’s thoughts?
Based on the excerpts people have posted, there is no mention of actual vs calculated OAS. Is this correct?
If a question comes up on the exam that asks about the effects of volatility on OAS, do we agree that we should go with the below:
There is an inverse relationship.
Higher Interest Rate Volatility decreases OAS
Lower Interest Rate Volatility increases OAS
 
I don’t understand why Z-spread would change with volatility. Isn’t Z-spread assuming zero volatility.
 
Take the basic equation:
OAS = Z-spread - Option Cost
To s2000magician’s point above, everything is affected, it’s just a matter of what variables you change.
so, if you assume price is fixed, and change your vol assumption, OAS changes and Z-spread stays the same (Z-spread doesn’t change because you haven’t changed the price of the security)
if you assume price adjusts with vol (which is what really happens in the market), then OAS stays the same and z-spread changes (put differently, you require the same OAS despite the vol change so when you use the same OAS to discount back you get a different price)
This is why the reading states “For a given bond price”
 
Yes, for a given bond price (stupid as that is):
  • An increase in the assumed volatility of interest rates will increase the value of call and put options, decreasing the OAS on callable bonds and increasing the OAS on putable bonds
  • A decrease in the assumed volatility of interest rates will decrease the value of call and put options, increasing the OAS on callable bonds and decreasing the OAS on putable bonds
 
I understand how an increase in volatility of rates increases the option cost, decreasing the OAS on a callable bond.
But how does an increase in volatility of rates increase the OAS on a puttable bond?
Can someone please explain this looking at OAS = z-spread - option cost
 
Option cost is negative for a putable bond. Higher interest rate volatility makes the cost negativer, and subtracting that from the Z-spread makes the OAS positiver.
 
Nice, got it thanks.
So from the perspective of the bond holder the put option cost is negative. But what about from the perspective of the bond issuer, or do we not consider the issuer since they do not hold the put?
 
They’ve sold the put to the bond holder, so they borrow at a lower effective rate that would relative to a callable or option free bond.
 
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