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FRM Part II · FRM Exam Part II · Arbitrage Pricing with Term Structure Models

A trader finds that a putable bond has an OAS of 40 bps versus a Z-spread of 25 bps on the same benchmark curve. Which conclusion is consistent with these figures?

The put has positive value to the investor. Because the investor owns the option, the Z-spread is depressed by the option's value, and removing it gives a higher OAS. Here the OAS of 40 bps exceeds the Z-spread of 25 bps by the 15 bps option value.

  1. AThe embedded put has positive value to the investor, so the OAS exceeds the Z-spreadCorrect
  2. BThe embedded put has positive value to the issuer, so the OAS exceeds the Z-spread
  3. CThe bond must be mispriced because the OAS can never exceed the Z-spread
  4. DThe bond carries no optionality because the two spreads differ

Explanation

For a putable bond the investor owns the option, which raises the bond's price. The Z-spread therefore understates the spread that remains once the option value is removed; the OAS is higher: OAS = Z-spread + option cost in bps, here 25 + 15 = 40. The claim that OAS can never exceed the Z-spread applies only to callable bonds.

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