option-adjusted spread for mortgage back securities

[Liming]

Dear David,

I need to bother you again with another question that has been puzzling me for long. This is about the option-adjusted spread for mortgage back securities.
According to page 181 of FRM handbook 5th edition, ‘... OAS = Static spread - Option cost. During market rallies, long-term Treasury yields fall, ... pushing up the yield spread.’ Although I understand the equation a bit, I don’t quite follow the logic of what happens during market rallies in the book’s description.
1) why does market rallies imply Treasury yield fall? Does this rally refer to rally in Treasury bond market only? From my understanding of the market, the recent credit crunch has lead to a overall market liquidity freeze, associated with a fall in Treasury yield, due to investors’ flight to quality. Therefore, I’m confused about whether a rally indicates yield fall or a market liquidity contraction leads to yield fall?
2) In the described scenario, the bond is likely to be prepaid early. I think this means that the option sold implicitly to bond issuers is more ‘in - the - money’, thereby increasing the cost of writing the option. However, I don’t quite understand why as the book describes, ’ their option cost increases, pushing up the yield spread’? I can’t see the necessary link between the option cost and the yield spread. I’m just guessing that maybe it’s because OAS should maintain stable, therefore requiring the ‘Static spread’ to increase so as to adjust to the higher option cost?
Thank you very much for your kind answer!

Cheers!
Liming

 

[David Harper CFA FRM]

I struggle a bit with Jorion's phrasing here, too ... here is what I *think* he means:

1. I think he refers to any generic increase in Treasury prices, which corresponds to yield decreases, whether it be increased demand, flight to quality, decreased supply, etc .. I think he is trying to explain why it could be possible that the theoretical term structure of Treausury spot rates (i.e., what we use for pricing riskless cash flows) could shift *down*, yet spreads (i.e., risky yield - risky yield) could increase...

2. I think what you say is exactly his point: "I’m just guessing that maybe it’s because OAS should maintain stable"
if we think about:

callable bond price = option free bond price - value of option

... what happens as yield is decreasing?

1. the value of the option to call (or, for the borrower to "exercise the option" to prepay in order to refinance at the lower rate) is increasing in value.
2. the price of the option-free bond is decreasing (i.e., lower yield --> higher price)

impact on callable bond price = (increase in price or option-free bond) - (increase in value of option)

this structurally corresponds to:
OAS = static spread - option cost; i.e., the OAS incorporates the cost of the option...although we might rearrange into:

static spread = OAS + option cost
....the OAS is more stable precisely because it excludes the option cost, so as the yield is decreasing, the option cost is increasing, and this is increasing the static spread which is "infected" by the option cost.

Put another way, as I think this though, the investor in a callable bond earns:
the riskless yield +
credit spread +
spread for the call (mortgage: prepayment) option

I think he is saying: as yields decrease (e.g., flight to quality, rally in Treasuries):
riskless yield (by definition) decreases,
assume credit spread is the same
but spread for call option increases
so that total spread (credit spread + spread for call opton) will increase, or "yield spreads on mortgages often widen" ...the key is that he refers to the *spread* and the spread includes the higher option cost.

hope that helps, David

 

[hsuwang]

Hello David,

When I try to tackle the concepts in Fabozzi chapter 1 (MBS Valuation) regarding OAS and static spread, I think it is useful to equate the following:

Callable bond price = option-free bond price - option value
OAS = static spread - option cost

In most of the cases, it is intuitive to interchange between the terms, but I'm not quite getting the concept that an MBS is trading "cheap" when OAS is high and option cost is low. substituting the terms - MBS is trading cheap when Callable bond price is high, and option value (cost) is low. This is saying that the bond is less likely to be called, and therefore it'll have a higher price, and thus a safer investment?

This seems like a testable concept and I'm really not getting it but rather depending more on memorization...

Thanks!