MBS OAS and OPTION COST nothing, cheaper, example, numbers, bigger

morebeans

Schweser study session 15, page 281 has this example, I dont think this is a violation of copy rights laws, nothing "intellectual" going on, just a few numbers....

Tranche OAS Z duration
I 92 142 4.25
II 118 134 4.25

according to the answer the cheaper one is the one with the bigger OAS and smaller option cost

I has option cost of 50
II has option cost of 16

so II has higher OAS and lower option cost, II is cheaper

now I dont get why do we look at option cost, should not OAS be enough?

The reason we did OAS was to account for the option? Why we gotta deal with it again!!!

According to Dr. Holmes (schweser vids), if you have a higher OAS and a higher option cost it is not surely the cheapest, it requires further analysis beyond the curriculum..

I home someone out there mastered it...

Thanks guys

economicz

Are you finding problems which gives higher OAS and option cost?

yospaghetti

no, i am finding a problem with why do i even need to look at option cost?

should not i just look at the one with the higher OAS and say, thats the "good" ???

I thought the whole point of OAS was to take out the effect of the option, and therfore it should facilitate direct comparison...

After all Dr. Homles keeps calling it the "options removed spead".

So if you can please explain why do we have to look at option cost.

Thank you EoghanLyons

eoin

I agree with you in that the first consideration should be just to look at the OAS. The greater the OAS, the greater your risk-free + OAS yield, and hence the cheaper bond value.

Now as for the situation with the option cost, if I had to venture a guess, it would be a scenario where the option cost is large and has high volatility. Greater volatility would mean there is a greater chance that the option cost would be greater, and therefore result in a smaller OAS. The probability may require testing. The general static model doesn't work (like a black-scholes) since it assumes a constant variance over values.

I'm not going to get bent out over it; the point is to know that you use the OAS to evaluate bonds with embedded options. I'm pretty sure you can guess the correct A, B, or C from there.

If I come across a "real" explanation, I'll report back.

tarunajwani

When you're comparing bonds with the same maturity, coupon, and duration you may only look at OAS and then your reasoning of higher OAS = cheaper bond holds true.

If you are comparing bonds with different effective duration, for example, you will need to look at the difference between Z spread and OAS (=option cost).
For bonds with longer duration, an investor would demand a much higher OAS, on a relative basis, to compensate for higher risk. This is when you look at option cost.

Uranus08

Thank you Iginla2010.

That pretty much answers it, I might spend some time on it later to get a deep understanding. But for now what you said makes sense.

Thanks again