OAS and default risk

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Xtra

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Does OAS exclude default risk? If so why?
Thanks
 
‘OAS excludes default risk from its calculation; therefore OAS has limited applicabilty in the analysis of speculative grade bonds’ Pg 96 CFA text Question 26
 
OAS measure the spread between bonds with embedded options and a similar bond without. it measures the cost of having that optionality embedded.
default risk is measured by the credit spread which is the spread between a treasury security (assumed to be default free) and a non treasury security.
 
Kwonyboy Wrote:
——————————————————-
> OAS measure the spread between bonds with embedded
> options and a similar bond without. it measures
> the cost of having that optionality embedded.
>
> default risk is measured by the credit spread
> which is the spread between a treasury security
> (assumed to be default free) and a non treasury
> security.
Correct me if I’m wrong but this sounds like Level 3 OAS is different from Level 1 and 2 ones. In level 1 we have known that OAS is different from z-spread because it has removed option risk. Therefore, level 1 OAS still has default risk, interest rate risk, reinvestment risk, etc.
Anyway I have read that EOC solution and I guess we have to follow it.
 
sorry my post was misleading. default risk isn’t measured by the credit spread.
Both OAS and Z-spreads measure credit spread and as you correctly state, the z-spread removes the option risk.
In reply to Xtra’s original query, i belive the reason why OAS is not particularly useful is because there has been a reduction in corporate structures that contain embedded options.
 
this issue drives me nuts. I don’t get how OAS “excludes default risk” as per CFAI UNLESS its being used to compare two otherwise identical securities, one WITH option and the other WITHOUT
however, according to Wiki, OAS is generally measured viz Treas. In that case, if WOULD capture default risk, no? If i looked at an OAS of a callable Corporate viz Treas, it most certainly WOULD include default risk, no?
 
For this test, i’m writing “does not include”
However that differs from level I, Level II, and common fkng sense. Typical CFAI dbag stuff.
 
I think the answer is more that the OAS model does not assume defaults.
OAS spread prices credit risk/spread risk etc in the secondary market. That is more what CFAi wants you to know from the MBS section.
The model used to price MBS does not include a default assumption?
 
Many U.S. practitioners prefer to value investment-grade credit securities in terms of option-adjusted spreads (OAS) so they can be more easily compared to the volatility (“vol”) sectors (mortgage-backed securities and U.S. agencies).3 But given the rapid reduction of credit structures with embedded options since 1990 (see structural discussion above), the use of OAS in primary and secondary pric- ing has diminished within the investment-grade credit asset class. Moreover, the standard one-factor binomial models4 do not account for credit spread volatility. Given the exclusion of default risk in OAS option-valuation models, OAS valua- tion has seen only limited extension into the higher-risk markets of the quasi- equity, high-yield corporate, and EMG-debt asset classes.
(Level III Volume 4 Fixed Income and Equity Portfolio Management , 4th Edition. Pearson Learning Solutions p. 76).
Answer is more to do with the model I think.
 
OAS does not take default risk into account. It is only measuring the effect of the embedded option. So default risk is still present, but it is just not considered when the OAS is calculated. Question 26 that Xtra mentioned was specifically concerned with measuring the risk of speculative grade bonds, for which default is a big concern. So if you’re worried about default, the OAS is not very useful. OAS can still be calculated though for a bond with serious default risk.
 
isn’t OAS calculated using binary tree?
If so, you never mark any end of binary tree as “default”, which means the calculation result does not consider any possibility of “default”.
my understanding, open to critique.
 
Basically, you’re pretty much all wrong. Read the answer.
OAS is an option adjusted spread above benchmarks. It only reflects credit (and other factors such as maturity, liquidity etc.)
Above says that, in adjusting for the option, the credit risk of the option is not taken into account - so bonds with optionality are less comparable, on a credit risk basis, to bonds without optionality because you still include the credit risk of the option - limiting the “like-for-like” comparability of credit risk.
In a pure theory standing, there is no doubt that OAS are constructed to reflect comparable spreads between those with options and those without. If you put in the exam that OAS does not reflect credit risk you will almost certainly be punished, because it does - just also includes credit risk of the option.
 
The question is “Does OAS exclude default risk?” Yes, OAS excludes default risk FROM ITS CALCULATION. Any bond with an embedded option can have an OAS calculated for it. Just because we calculate OAS, it doesn’t mean that the bond does not have default risk. So we need to be clear whether we are talking about the bond or the OAS. The bond contains default risk, but the OAS does not include default risk into its calculation.
So sins, you are wrong. The OAS does not “only reflect credit.” The OAS only reflects the optionality. The bond itself still has many other properties.
 
LobsterBoy Wrote:
——————————————————-
> The question is “Does OAS exclude default risk?”
> Yes, OAS excludes default risk FROM ITS
> CALCULATION. Any bond with an embedded option can
> have an OAS calculated for it. Just because we
> calculate OAS, it doesn’t mean that the bond does
> not have default risk. So we need to be clear
> whether we are talking about the bond or the OAS.
> The bond contains default risk, but the OAS does
> not include default risk into its calculation.
>
> So sins, you are wrong. The OAS does not “only
> reflect credit.” The OAS only reflects the
> optionality. The bond itself still has many other
> properties.
100% correct and from the book.
Obviously when looking at the spread it is implying credit risk otherwise OAS would be 0. The model however according to the book models the option not the credit risk.
Remember OAS is a derivation of other spreads accounting for the option not attempting to calculate credit spread risk.
 
LobsterBoy Wrote:
——————————————————-
> The question is “Does OAS exclude default risk?”
> Yes, OAS excludes default risk FROM ITS
> CALCULATION. Any bond with an embedded option can
> have an OAS calculated for it. Just because we
> calculate OAS, it doesn’t mean that the bond does
> not have default risk. So we need to be clear
> whether we are talking about the bond or the OAS.
> The bond contains default risk, but the OAS does
> not include default risk into its calculation.
>
> So sins, you are wrong. The OAS does not “only
> reflect credit.” The OAS only reflects the
> optionality. The bond itself still has many other
> properties.
So according to your / supposed cfa logic, given that OAS = z-spread - option cost (look it up or go and work in the debt markets for about 20 minutes) and we know that the z spread incorporates the inflation premium, default premium, liquidity premium, maturity premium and tax premium versus the benchmark (ok not maturity if same benchmark is used), the option cost therefore includes all the credit risk?
The OAS actually adjusts for optionality to make the bond comparable with bonds without optionality so you have a comparable spread. Remember that a callable bond has it’s spread reduced because they are short a call to the issuer. The whole reason for having the OAS is so you can compare the bonds. If they dont equal one another, and all else being equal, you can arb it by stripping the option.
 
sins, I’m not sure what point you are trying to make. But I think we agree eachother. You wrote “The OAS actually adjusts for optionality to make the bond comparable with bonds without optionality so you have a comparable spread.” So since OAS adjusts for optionality, it does not include default risk in its calculation. That’s what the original question was. The bond still has default risk and the default risk influences the price of the bond, but the question was not about the bond. It was about the spread. If you are comparing one bond with an embedded option to an identical bond without an embedded option, then the default risk cancels out.
 
If OAS reflected credit risk then you couldn’t make an apples to apples comparison between a AAA MBS and a AA MBS.
 
bpdulog Wrote:
——————————————————-
> If OAS reflected credit risk then you couldn’t
> make an apples to apples comparison between a AAA
> MBS and a AA MBS.
Lobster boy, agree if and only if you are comparing like for like bonds (ie same credit risk). You would see on a bloomberg screen OAS = ms + x bps. If you’re looking at this in isolation, then the x bps will be inclusive of credit risk (amongst the other factors discussed above).
Bpdulog, that is incorrect. OAS is not for comparing MBS with MBS - it’s for comparing bonds with optionality, an MBS for example to a non-callable corporate.
Eg
AA rated MBS - Z = ms + 220bps, OAS = ms + 180bps
I would compare this to an AA rated corps OAS (which will equal z) and if all else being equal the corporate bond has a speed of less than 180bps, I would buy the MBS.
Trust me on this.
 
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