What exactly does the OAS compensate investors for? Is it: all the risks that they face re the bond (i.e. default, liquidity, interest rate and option risk), just the option risk, or all of the risks except the option risk? The notes would seem to imply a, defining the OAS as the "spread to short-term interest rates that equates the theoretical price of a bond to its market price." However, the solution to Assignment X5 question 2 gives c. Any help on this would be greatly appreciated.
I think it is c. You explicitly allow for the option through the model which calculates the "theoretical price". The spread that equates this theoretical price with the market price will compensate for all other risks.
Thanks. I think I see it now. If we wanted to get the credit spread for a normal bond we would find the constant addition to the risk-free yield curve that equated the theoretical price of the scheduled payments to the market value. If we considered the expected payments (i.e. allowing for the probability of default), the interest rate would not include a credit risk premium (assuming risk-neutral investors?). Similarly, here we are looking at the cashflows allowing for the prepayment risk. The resultant spread required to equate the theoretical and market prices must therefore exclude the option-risk premium (again, assuming risk-neutral investors who don't require additional compensation for risk beyond the expected loss). Thanks again.
