OAS & Z relationship

[rexthedog]

Yo,
Getting a bit confused on the relationship here.
OAS reflects credit and liquidity risk. Is this on a corporate bond? Its the spread we need to add to bring the computed price down to the fair price right? Is the OAS for binomial trees that are option free or with embedded options?
Where does the Z spread come in during all of this. I am seeing conflicting formulas on old AF posts that OAS = Z - OPTION COST and some saying OAS = Z +OPTION COST.
Basically, can someone please explain the difference between these and when which is used?
Cheers

 

[S2000magician]

The Z-spread is a spread added to the spot curve to get the price of a risky (e.g., corporate) bond. It covers all risks, including option risk.
The OAS is a spread added to the forward rates in a binomial tree to get the price of a bond with embedded options. It removes the option risk, but covers all other risks.
Z-spread − OAS = option cost (in additional yield paid by the issuer)

 

[JayWill]

I found this thread to be helpful: http://www.analystforum.com/forums/cfa-forums/cfa-level-i-forum/91310184, which you may have already seen. Of course Bill (S2000magician) had a comment in it as this is his wheelhouse. I’m afraid I don’t have much to add though, as I still struggle with this conceptually as well. I need to spend more time thinking about it before the exam, because I have a weird feeling that Fixed Income is going to be tested hard this year, and I still struggle with some of the concepts. Moreso than any other subject.