Does OAS include default risk in its calculation? inherently, google, default, includes

willsucceed

I was completing question 26 of Reading 29 in the CFA books and the answer states..."OAS has limited use in the analysis of speculative grade bonds because default risk is excluded from the calculation." No doubt we all know the formula OAS = Z-spread - option cost. I was of the belief that it inherently includes a consideration of default risk. A simple google search provides multiple sources that state the OAS can be viewed as the compensation an investor receives for assuming a variety of risks (e.g. liquidity premium, default risk, model risk), net of the cost of any embedded options.

Any of you gurus got any thoughts?

Windjammer

Is the default risk factored in the prices of junk bonds?

nannan66

Junk bonds could have embedded options; OAS is recommended for spread analysis of bonds with embedded options. Kind of confusing to me.

IMO, the default risk has been factored in the prices of junk bonds(high yield bonds), so OAS shall reflect the default risk. This is not contradictory with what's in CFAI book...The default risk is not included in the OAS calculation, just like model risk not included in the OAS calculation.

Valores

OAS cannot cover default risk , because default is highly firm specific.

Plus in L2 if I remember right, the OAS calculation methodology mainly was applied to examples from MBS and used prepayment related data .i.e. the option part had to do with convexity and not default possibility. Default was not even a big deal up until 2008 anyway

skycfa

I think we're talking about two different things here:

1. The actual adjustment made to the z spread in order to take into account the effect of options.
2. The spread that remains after the adjustment has been made.

In regard to #2, I would think it would still reflect default risk otherwise it would be equivalent to the risk free rate.

NO EXCUSES

Analyze_This

nice one, that clarifies it.

cheers

Analti_Calte

Since OAS has limited use in the analysis of speculative grade bonds , which other spread shall be used for junk bond analysis?

lcw77

not sure of what context they provided it, but i dont see how it would not provide an embedded default premium. Z spread is the spread over the whole treasury curve, so theoretically wouldnt the z-spread of a treasury be zero?

To get a meaningful number you must incorporate default risk in my mind.