CFA Practice Question

There are 252 practice questions for this study session.

CFA Practice Question

For a callable bond, the higher the assumed volatility of interest rates, the ______ the option adjusted spread.

A. higher
B. lower
C. there is no relationship between the two measures.
Correct Answer: B

User Contributed Comments 12

User Comment
sharapov option price is excluded from OAS, so there should be no relation
tengo I agree with sharapov but I think we are supposed to assume "all else are equal" - then the oas would shrink.
katybo OAS will depend on the volatility assumption. The higher the volatility the lower the OAS.
danlan2 This is for callable and not putable bond, right?
ehc0791 holding the price constant, the higher the volatility, the lower the oas (= Z-spread - option cost)
bmeisner This is only for a callable bond. Higher volatility always increses the embedded option value. If the investor owns the option (e.g. putable) then the OAS is higher for higher volatility, meaning the bond is cheaper because it offers a higher option adjusted yield.
giroth Option cost = Z-Spread - OAS. Higher vol --> Increased Option Cost, which reduces OAS
Allen88 Thanks giroth
chris54321 u are gona pass fo sho giroth
davidt876 worth noting the difference between the treatment of terms option cost and option value at this point:

option value:
callable bond value = straight bond value - call option value
putable bond value = straight bond value + put option value

option cost:
embedded option bond value = straight bond value - option cost

where put option cost < 0 (and therefore always increases value)
and call option cost > 0 (and therefore always decreases value)
davidt876 my problem with this question is that as volatility increases the option cost increases and the value of the callable bond decreases. therefore the calculated z-spread would increase - right?

so if OAS = z-spread - option cost; and the answer is that OAS goes lower, then we're assuming the option cost increases more than the z-spread?

but that doesn't make sense because as volatility increases the straight bond yields are (according to the notes) unaffected, while callable bond yields increase. if OAS is supposed to remove the effect of the embedded option, then surely it has to increase as the gap between the two yields increases?

am i tripping?
davidt876 yeaaa i was trippin. found this explanation online:

"The Z-spread is your compensation when interest rates are stable… hence, the term, zero-volatility spread. So if volatility goes up, Z-spread won’t budge. Meaning OAS must decrease."
You need to log in first to add your comment.