Week 9 Flashcards
When do we use OAS spread?
We use the OAS in the following cases:
◼Corporate bonds with embedded options
E.g., callable and putable bonds
◼Mortgage-backed securities
◼And ABS with prepayment option, and the prepayment option is usually exercised
E.g., closed-end home equity loans with high quality borrowers
When do we use Z-spread
In particular, we use the Z-spread in the following circumstances:
◼Corporate bonds with noembedded options
◼ABS with noprepayment option
E.g., ABS backed by credit card receivables (because the underlying is a non-amortizing asset)
◼And ABS with prepayment option, but the prepayment option is usually notexercised
E.g., ABS backed by auto loans
What are the 4 drawbacks of OAS?
- Model Dependency – OAS relies on valuation models with assumptions, introducing modeling risk.
- Simulation Calibration Issues – Interest rate paths in Monte Carlo simulations must be adjusted to match market prices of benchmark securities, but the adjustment methods vary by vendor and can be arbitrary.
- Term Structure Complexity – A single OAS might not capture the full picture if different maturities require different OAS values.
- Assumption Sensitivity – OAS is highly sensitive to assumptions about interest rate volatility and prepayments, reinforcing its modeling risk.
What is Monte Carlo?
The Monte Carlo method is an alternative method for simulating a sufficiently large number of potential interest rate paths in an effort to discover how a value of a security is affected
- used when securities’s cash flow is path dependent
