Option Adjusted Spread

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Option adjusted spread (OAS) is the flat spread over the treasury yield curve required to discount a mortgage-backed security's 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:

• 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 IRs 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 0471385875

External links

• [The Society of Actuaries review of the application of OAS to insurance, and other option adjustments]
• [OAS analysis using Monte Carlo with many power point examples] (Deals with implying the OAS from the bond market prices. Estimate of minimum OAS = 150 basis points.)

 

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