RMontgomery

passcfaforsure wrote:
Thanks. So confused. For Monte carlo method , each node has to add OAS to compensate for the optionality. while OAS already dedcucted the Optionality and leaves only (liquidity +credit risk). if they value the bond with option , they should keep the optionlity in the spead to compensate for the risk, why use OAS ( without the otptionlity).
Really appreciate your time. please add some comments
I think that’s where most people initially get confused. Why OAS without option risk is used to value bond with options. The idea of using OAS is really to find the spread of the bond against a reference benchmark without the option cost. Because of its embedded optionality, the value at each node in the binomial tree is not necessarily equal to its discounted present value of it’s one period ahead value. The OAS is the spread that is added to every single spot rate to make the value of the bond at t = 0 similar to the market value.
With this, we will have eliminated the option cost and we can use the OAS to compare against other similar option free bond or similar callable or putable bond.