CURRENT COUPON VS. OAS
- Thread starter kasoker
- Start date
ktm,
Yes. "Current coupon" is *not* a term we encounter in the FRM; perhaps it refers to the coupon rate dividend by bond price. We usually refer to (e.g) a $100 par bond paying an 8% semi-annual coupon. As this bond pays $4 every six months, if the bond's market price is (eg) 94, then the current yield is $8/94 = 8.51% and I supposed the current coupon might refer to the "current yield." If so, it is observable and straightforward
Contrast the OAS which is far less observable and requires a model to infer: it is the spread added to the spot rate curve that produced an model price = observed market price. (Not totally unlike option implied volatility, which solves for implied volatility to produce an option model value = option marker value). In this case, the bond (likely a callable/putable bond) has a market price equal to (eg) 93 and discounting the cash flows at the theoretical spot rates would give a model price equal to (eg) 97 [as these rates are ~ riskless, must be higher number!]. The OAS is the (yield) spread constant that must be added across the curve to produce model [ discounted @ spot + OAS] = market price of 93. However, now add one key thing: instead of a single valuation, assume a monte carlo simulation with multiple valuations (why? to account for scenarios where the options is variously triggered. A vanilla bond does not need scenarios--it's cash flows don't change with interest rates--like a bond with embedded option needs scenarios).
hope this helps, David
Yes. "Current coupon" is *not* a term we encounter in the FRM; perhaps it refers to the coupon rate dividend by bond price. We usually refer to (e.g) a $100 par bond paying an 8% semi-annual coupon. As this bond pays $4 every six months, if the bond's market price is (eg) 94, then the current yield is $8/94 = 8.51% and I supposed the current coupon might refer to the "current yield." If so, it is observable and straightforward
Contrast the OAS which is far less observable and requires a model to infer: it is the spread added to the spot rate curve that produced an model price = observed market price. (Not totally unlike option implied volatility, which solves for implied volatility to produce an option model value = option marker value). In this case, the bond (likely a callable/putable bond) has a market price equal to (eg) 93 and discounting the cash flows at the theoretical spot rates would give a model price equal to (eg) 97 [as these rates are ~ riskless, must be higher number!]. The OAS is the (yield) spread constant that must be added across the curve to produce model [ discounted @ spot + OAS] = market price of 93. However, now add one key thing: instead of a single valuation, assume a monte carlo simulation with multiple valuations (why? to account for scenarios where the options is variously triggered. A vanilla bond does not need scenarios--it's cash flows don't change with interest rates--like a bond with embedded option needs scenarios).
hope this helps, David
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Hi David:
I was wondering about this myself. I am going out on a limb here because I am not an expert. So please feel free to correct me.
I think ktm maybe referring to current coupon rate (CCR) in the context of fair loan condition (Tuckman, pages 460, 466).
There are similarities as well as differences between CCR and OAS.
One similarity is they both involve finding a yield after removing the embedded-option value. As you summarize above, OAS is a constant spread added to the spot yield curve to equate model price to market price. In computing CCR, on the other hand, we leave the yield curve intact but adjust the cashflow stream (by adjusting the mortgage rate).
According to Tuckman (page 460), “the fair loan condition requires that at origination of the loan the present value of the mortgage cash flows (PV(CF)) minus the value of the prepayment option (PP) equals the initial principal payment (BB). The mortgage rate that satisfies this condition in the current interest rate environment is called the current coupon rate.” In short:
PV(CF) - PP = BB
To achieve this equality, the term PV(CF) is adjusted because PP and BB are fixed at loan origination. The adjustment to PV(CF) is accomplished by leaving the current yield curve intact but changing the mortgage rate, thus changing the CF stream.
Over time, as the mortgage seasons, the yield curve evolves, and so must the current coupon rate. This is in contrast to the existing mortgage rate, which is fixed since origination or since the most recent re-financing negotiation. The difference between the two rates is one of the factors driving the incentive function in the prepayment model (page 466).
I was wondering about this myself. I am going out on a limb here because I am not an expert. So please feel free to correct me.
I think ktm maybe referring to current coupon rate (CCR) in the context of fair loan condition (Tuckman, pages 460, 466).
There are similarities as well as differences between CCR and OAS.
One similarity is they both involve finding a yield after removing the embedded-option value. As you summarize above, OAS is a constant spread added to the spot yield curve to equate model price to market price. In computing CCR, on the other hand, we leave the yield curve intact but adjust the cashflow stream (by adjusting the mortgage rate).
According to Tuckman (page 460), “the fair loan condition requires that at origination of the loan the present value of the mortgage cash flows (PV(CF)) minus the value of the prepayment option (PP) equals the initial principal payment (BB). The mortgage rate that satisfies this condition in the current interest rate environment is called the current coupon rate.” In short:
PV(CF) - PP = BB
To achieve this equality, the term PV(CF) is adjusted because PP and BB are fixed at loan origination. The adjustment to PV(CF) is accomplished by leaving the current yield curve intact but changing the mortgage rate, thus changing the CF stream.
Over time, as the mortgage seasons, the yield curve evolves, and so must the current coupon rate. This is in contrast to the existing mortgage rate, which is fixed since origination or since the most recent re-financing negotiation. The difference between the two rates is one of the factors driving the incentive function in the prepayment model (page 466).
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