Option-Adjusted Spread (OAS)
What Is Option-Adjusted Spread (OAS)?
The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to consider a embedded option. Typically, an analyst utilizes Treasury yields for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price equivalent to the bond.
Understanding Option-Adjusted Spread (OAS)
The option-adjusted spread assists investors with looking at a fixed-income security's cash flows to reference rates while likewise esteeming embedded options against general market volatility. By separately analyzing the security into a bond and the embedded option, analysts can decide if the investment is beneficial at a given price. The OAS method is more accurate than essentially contrasting a bond's yield with maturity to a benchmark.
The option-adjusted spread considers historical data as the variability of interest rates and prepayment rates. These elements' estimations are complex since they endeavor to model future changes in interest rates, prepayment behavior of mortgage borrowers, and the likelihood of early redemption. Further developed statistical modeling methods, for example, Monte Carlo analysis are frequently used to anticipate prepayment probabilities.
Options and Volatility
A bond's yield to maturity (YTM) is the yield on a benchmark security, which can be a Treasury security with a comparable maturity plus a premium or spread over the risk-free rate to repay investors for the additional risk.
The analysis gets more convoluted when a bond has embedded options. These are call options, which give the issuer the right to recover the bond prior to maturity at a preset price, and put options that permit the holder to sell the bond back to the company on certain dates. The OAS changes the spread to account for the potential changing cash flows.
The OAS considers two types of volatility facing fixed-income investments with embedded options: changing interest rates, which influence all bonds, and prepayment risk. The shortfall of this approach is that evaluations depend on historical data yet are utilized in a forward-looking model. For instance, prepayment is typically estimated from historical data and doesn't consider economic movements or different changes that could happen from here on out.
OAS versus Z-Spread
The OAS ought not be mistaken for a Z-spread. The Z-spread is the consistent spread that makes the bond's price equivalent to the current value of its cash flow along each point along the Treasury curve. Be that as it may, it does exclude the value of the embedded options, which can immensely affect the current value. The Z-spread is otherwise called the static spread due to the steady feature.
The OAS actually changes the Z-spread to incorporate the value of the embedded option. It is, consequently, a dynamic pricing model that is exceptionally dependent on the model being utilized. Additionally, it takes into account the comparison utilizing the market interest rate and the possibility of the bond being called early — known as prepayment risk.
Model: Mortgage-Backed Securities
For instance, mortgage-backed securities (MBS) frequently have embedded options due to the prepayment risk associated with the underlying mortgages. In that capacity, the embedded option can altogether affect the future cash flows and the current value of the MBS. OAS is hence especially helpful in the valuation of mortgage-backed securities. In this sense, the prepayment risk is the risk that the property owner might pay back the value of the mortgage before it is due. This risk increments as interest rates fall. A bigger OAS infers a greater return for greater risks.
Features
- The option-adjusted spread (OAS) measures the difference in yield between a bond with an embedded option, like a MBS or callables, with the yield on Treasuries.
- Utilizing historical data and volatility modeling, OAS looks at how as a bond's embedded option can change the future cash flows and consequently the overall value of the bond.
- Embedded options are provisions included with some fixed-income securities that permit the investor or the issuer to do specific activities, like calling back the issue.
