Question

2. You are considering the purchase of a callable corporate bond. You have two analytical systems available to you to value the bond. In one system, System A, the vendor uses the on-the-run Treasury issues to construct the theoretical spot rate that is used to construct a model to compute the OAS. The other analytical system, System B, uses the on-the-run issue for the particular issuer in constructing a model to compute the OAS.

a. Suppose that using System A, you find that the OAS for the callable corporate you are considering is 50 basis points. How should you interpret this OAS value?

b. Suppose that using System B, you find that the OAS computed is 15 basis points. How should you interpret this OAS value?

c. Suppose that a dealer firm shows you another callable corporate bond of the same credit quality and duration with an OAS of 40 basis points. Should you view that this bond is more attractive or less attractive than the issue you are considering for purchase?

Answer 1

Option Adjusted Spread (OAS) is used in valuing embedded options. This measures how the fixed income security is changing with the change in the expected cashflows and the present value of securities.

a. In system A, the vendor uses the on-the-run treasury issues to construct a theoretical spot rate. Here, the OAS on the callable corporate bond is 50 points.

Therefore, it states that the bond is priced more than 50 basis points of yield than the treasury issues.

b. In system B, the vendor uses on-the-run issue for the particular issuer in constructing a model. Here, the OAS on the callable corporate bond is 15 points.

Therefore, it states that the bond is priced only more than 15 basis points of yield than the treasury issues.

c. A dealer of firm shows another bond that has same credit quality and duration that is available with 40 basis points. Here, the OAS is 40 basis points and hence the price of the bond is less.

Therefore, the bond is more attractive than the issue.