OAS

[E]

Chapter 34 of the Handbook (pp. 791-792) describes the OAS for a callable bond as the additional spread over a noncallable bond yield curve that is needed to equate the PV of future callable bond cash flows to the actual callable bond's market price (essentially a risk premium for the call option expressed in terms of the noncallable yield curve).

They go on to say that increased rate volatility will lower the OAS for a callable bond (huh?). From the investor's (market's) perspective, the price of a callable bond in a volatile rate environment should be lower than the price of a comparable noncallable bond because the value of the call option to the issuer increases. To me, that says the investor's yield on a callable bond should be higher than the yield on a noncallable bond. This difference should come from a higher OAS (applied to the noncallable bond forward curve). . . So why does the book say the OAS will decrease due to rate volatility?

[E]

Nevermind. I think my initial interpretation of OAS was off. If OAS = Total Yield Spread - Option Cost, and you think about the sign of the option cost value, I can see why OAS would increase/decrease for various types of optionality.