- Option-adjusted spread
Option adjusted spread (OAS) is the flat spread which has to be added to the treasury yield curve in a pricing model (that accounts for embedded options) to discount a security payment to match its market price. OAS is hence model dependent. This concept can be applied to a mortgage-backed security (MBS), option, bond and any other interest rate derivative. In the context of an MBS, the option relates to the right of property owners, whose mortgages back the MBS, to prepay the full mortgage amount.
- Variable interest rates
- Variable prepayment rates.
Designing such models in the first place is complicated because prepayment variations are a behavioural function of the stochastic interest rate. (They tend to go up as interest rates come down.)
OAS is an emerging term with fluid use across MBS finance. The definition here is based on Lakhbir Hayre's Mortgage Backed Securities text book. Other definitions are rough analogs:
- Take the expected value (mean NPV) across the range of all possible rate scenarios when discounting each scenario's actual cash flows with the treasury yield curve plus a spread, X. The OAS is defined as the value of X equating the market price of the MBS to its value in this theoretical framework.
Treasury bonds may not be available with maturities exactly matching likely cash flow payments so some interpolation may be necessary to make this calculation.
The word 'Option' in Option adjusted spread relates to the right of property owners, whose mortgages back the MBS, to prepay the full mortgage amount. Since mortgage-payers will only tend to exercise this right when it is favourable for them and unfavourable for the bond-holder, buying an MBS partly involves selling an option. This is the source of the difference between the option adjusted spread (OAS) and the Z-spread (which ignores embedded options).
Since prepayments rise as interest rates fall and vice versa, the basic (pass-through) MBS has negative bond convexity (second derivative of price over yield). The MBS-holder's exposure to property-owner prepayment has several names:
- extension or contraction risk
- prepayment risk
- reinvestment risk
This difference in convexity can also be used to explain the price differential from an MBS to a treasury bond. However, the OAS-figure is typically preferred. The discussion of the "negative convexity" and "option adjusted spread" on a bond is essentially a discussion of a single MBS feature (prepayment risk) measured in different ways.
- Convertible bonds must pay a similar increased yield (over the standard corporate bond) when they are callable by the issuing company.
- Monte Carlo techniques are used to derive the Option adjusted spread.
- Hayre, L. (2001). Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities. Wiley. ISBN 0-471-38587-5.
- Hull, J. C. (2006). Options, Futures and Other Derivatives. Pearson. ISBN 0-13-149908-4.
- Miller, Tom (2007). Introduction to Option-Adjusted Spread Analysis. Bloomberg Press. ISBN 978-157660-241-6.
- The Society of Actuaries review of the application of OAS to insurance, and other option adjustments. Society of Actuaries.
Bond market Types of bonds by issuer Types of bonds by payoutAccrual bond · Auction rate security · Callable bond · Commercial paper · Convertible bond · Exchangeable bond · Extendible bond · Fixed rate bond · Floating rate note · High-yield debt · Inflation-indexed bond · Inverse floating rate note · Perpetual bond · Puttable bond · Reverse convertible · Zero-coupon bond Bond valuation Securitized products Bond options Institutions
Wikimedia Foundation. 2010.
Look at other dictionaries:
Option adjusted spread — (OAS) is the flat spread over the treasury yield curve required to discount a security payment to match its market price. This concept can be applied to mortgage backed security (MBS), Options, Bonds and any other interest rate… … Wikipedia
option-adjusted spread — ( OAS) (1) A measurement of the return provided to an investor from a financial instrument that is either an option or that includes an option. The option adjusted spread calculations break up a security into separate cash flows. Each of those… … Financial and business terms
Option-adjusted spread — El Option adjusted spread (traducción literal del inglés, spread ajustado a opciones), conocido también simplemente como OAS, es la diferencia de tasas de interés que debe ser agregada a la curva soberana en los modelos de determinación de… … Wikipedia Español
Option-adjusted spread (OAS) — (1) The spread over an issuer s spot rate curve, developed as a measure of the yield spread that can be used to convert dollar differences between theoretical value and market price. (2) The cost of the implied call embedded in a MBS, defined as… … Financial and business terms
Option Adjusted Spread - OAS — Mainly used for fixed income products, OAS measures the yield spread that is not directly attributable to the security s characteristics. This is a measurement tool for evaluating price differences between similar products with different embedded … Investment dictionary
Spread — may refer to: *Statistical dispersion *Spread (food), an edible paste put on other foods *the score difference being wagered on in spread betting *the measure of line inclination in rational trigonometry *Temperature Dewpoint spread, dew point… … Wikipedia
Spread (finance) — Spread may refer to: *Bid/offer spread, between the buying and selling price of a commodity or security *Spread trade, between two related securities or commodities *Option adjusted spread, on mortgage backed securities where the borrower has the … Wikipedia
Option (finance) — Stock option redirects here. For the employee incentive, see Employee stock option. Financial markets Public market Exchange Securities Bond market Fixed income … Wikipedia
Credit spread (bond) — Finance Financial markets Bond market … Wikipedia
Credit spread (options) — Finance Financial markets Bond market … Wikipedia