volatility and OAS decrease, mortgage, therefore, structure, like

anothercfainnyc

When looking at a simple structure like a sequential pay CMO :
.
if in the base case we have a volatility of 10% and OAS of 50
then volatility can either
- increase to 30% and OAS decreases to 20
or - decrease to 10% and OAS increases to 77

if volatiltily increases, the value of the option increases and because im short the option, the value of a mortgage backed securty decreases. and vice verse for lower volatility, option embedded in mortgage security decreases and therefore value of securtiy decreases.

a higer OAS, means a cheaper security - ok - so now i dont understand why OAS gets larger for less volatitly ??

zhaoyp

pls any insights? if volatilty gets higher why don't i get compensated with more spread???

kickthatcfa

if vol goes up, the price of callable goes down, nomial spread (z-spread) goes up, OAS will stay the same.

if price stayed, OAS would decrease.

RMontgomery

yes, price stays the same. ok makes sense. once again, why z-spread (nom.spread) goes up? because Price goes down?

b_sea93

yes exactly, price goes donw and nominal and z spread just take the note as regular straight one

Swanand

i am sorry, i still have trouble understanding this concept.
if there is more volatility, then the value of my security is less, because call option has more value and value is reduced.
so if there is more volatility, shouldn^t then my security become cheaper?? (in terms of spread)
but no, it gets more expensive, since OAS goes down? i jsut dont understand this!

stalkey

if there is more volatility, then the value of my security is less, because call option has more value and value is reduced.

^this is correct and the nominal spread will go up

nominal spread = OAS + option value in spread

you know that OAS is the spread that is udjusted for optionality

it gets "cheaper" (based on lower price and higher nominal spread) but it is not real, because the value and spread changed just due to the change in option value and OAS stays the same (this is the important spread you look at when judging investment from credit risk point of view)

------------
so if there is more volatility, shouldn^t then my security become cheaper?? (in terms of spread)

^yes in terms of nominal spread (or z spread)

but no, it gets more expensive, since OAS goes down? i jsut dont understand this!

^because they assume that price did not change. If the price does not change, nominal spread does not change, but if option value changes the OAS must go down


in real world I think that if vol changes, price and nominal spread change and OAS stays the same. But in real life you can see Price and nominal spread in the market and you must estimate correct option value and OAS.

The thing is that in real life it is usually problem to get correct vol, therefore you use different vols to get OAS from nominal spread, and this is the analysis they are doing there

ayodayo

ok i think i got it.thank you.
one last question
if you have three tranches

current OAS 20% vola OAS when vola 10% OAS when vola 30%
1 36 56 13
2 63 93 13
3 67 89 -5

can you make a judgment from this and say which one you would choose?
i a am long the security, and vola goes up, i want the price decline to be as less as possible? or how do you look at an exampel like this?

maryli

what we can see is that change in option value when vol goes up to 30% would be:

1. 23
2. 50
3. 72

if OAS stays the same, the nominal spread will be increased by those numbers and prices will go down.

the durations of these bonds will be probably different and

your decisions will be based also on other objectives.

so I think you cannot make any decision based on these numbers only