Option adjusted spread (OAS) is the flat spread over the treasury yield curve required to discount a mortgage-backed security's (MBS) volatile coupon
payments to match its market price.
Definition
In contrast to the simple "yield curve spread" measurement of bond premium over a
pre-determined cash-flow model, the OAS describes the market premium over a model including two types of volatility:
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.
Convexity
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
option adjusted spread (OAS).
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 (Lakhbir Hayre's term)
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 discussion of a single MBS feature (prepayment risk) measured in different ways.
See also
- 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.
References
- Hayre, L. 2001, Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed
Securities, Wiley ISBN 0-471-38587-5
External links
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