Definition: Option-adjusted spread (OAS) measures the spread between a fixed income security and the risk-free rate of return, which considers how the embedded option in the fixed income security is likely to change the expected future cash flows and the present value of the security.
What Does Option Adjusted Spread Mean?
What is the definition of option adjusted spread? An option-adjusted spread converts the difference between the fair price and the market price of a fixed income security, typically a bond or a mortgage-backed security (MBS), into yield and calculates a spread that makes the two prices equal.
Analysts are using mortgage-backed securities because they contain embedded options to hedge the prepayment risk of the mortgage, and they are adjusting the risk-free rateto the embedded option to calculate how the expected cash flows and the present valueof the mortgage-backed security can change in the future. Interest rate volatility is very important for option-adjusted spreads because the higher the volatility, the lower the spread.
Let’s look at an example.
Example
George is a financial analyst at JP Morgan with a specialization in fixed income securities and bond pricing. His manager has asked George to estimate the option-adjusted spread of a 10-year, 11% callable option with a face value 1,000 and a present value of 95.3241 and a 10-year, 11% non-callable bond with a face value 1,000 and a present value of 95.6824.
Using these prices, George converts the difference between the fair price and the market price of each bond into yield to calculate a spread that equates the two prices as follows:
YTM (callable bond) Yield to maturity(YTM) =
((Face value/Bond price)1/Time period)-1 = ((1000 / 95.3241) 1/10) -1 = 0.049053 = 4.9053%
YTM (non-callable bond) Yield to maturity(YTM) =
((Face value/Bond price)1/Time period)-1 = ((1000 / 95.6824) 1/10) -1 = 0.045124 = 4.5714%
Therefore, the option-adjusted spread between the two yields is 4.9053% – 4.5124% = 0.3928%.
The option-adjusted spread analysis takes into account all the possible patterns in a bond’s cash flows reflecting all possibilities, and therefore, it makes an ideal tool when comparing the market price with the present value of a bond.
Summary Definition
Define Option-Adjusted Spread: OAS means difference between the yield of a risk-free rate of return and a fixed income security.
