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Option-adjusted spread

 
Investment Dictionary: Option Adjusted Spread - OAS

Mainly used for fixed income products, OAS measures the yield spread that is not directly attributable to the fixed income's characteristics.

Investopedia Says:
This is a measurement tool for evaluating price differences between similar products with different embedded options. A larger OAS implies a greater return for greater risks.

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Banking Dictionary: Option-Adjusted Spread (OAS)
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Method used in calculating the relative value of a fixed-income security containing an Embedded Option, such as a borrower's option to prepay a loan. OAS models, taking into account the effects of prepayments under various interest-rate scenarios, attempt to estimate the future value of a security. The methodology makes it easier to work out a side-by-side comparison of two different bonds, one of which has a call option (or prepayment option) and one that does not. The callable bond often has a higher yield to compensate for the early redemption feature.

Option-adjusted spreads are quoted as a fixed spread, or differential, over a benchmark security. In the United States the benchmark is U.S. Treasury issues in various maturities, since Treasury securities are not considered to have any credit risk. When first introduced, option-adjusted spreads were widely used in pricing mortgage-backed securities, but they have since been applied to other fixed-income securities, including structured notes and callable corporate bonds.

Wikipedia: Option-adjusted spread
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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 Derivative. 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.

Contents

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 a discussion of a single MBS feature (prepayment risk) measured in different ways.


See also

  • Z-spread
  • 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
  • Hull, J.C. 2006, Options, Futures and Other Derivatives, Pearson ISBN 0-13-149908-4

External links


 
 

 

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Investment Dictionary. Copyright ©2000, Investopedia.com - Owned and Operated by Investopedia Inc. All rights reserved.  Read more
Banking Dictionary. Dictionary of Banking Terms. Copyright © 2006 by Barron's Educational Series, Inc. All rights reserved.  Read more
Wikipedia. This article is licensed under the Creative Commons Attribution/Share-Alike License. It uses material from the Wikipedia article "Option-adjusted spread" Read more