Option-Adjusted Spread (OAS)

DEFINITION of 'Option-Adjusted Spread (OAS)'

A measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is adjusted to take into account an embedded option. Typically, an analyst would use the Treasury securities yield for the risk-free rate. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond.

BREAKING DOWN 'Option-Adjusted Spread (OAS)'

The option-adjusted spread helps investors compare a fixed-income security’s cash flows to reference rates, while also valuing embedded options against general market volatility. By separately analyzing the security's two components - the bond and the embedded option - analysts can determine whether the investment is worthwhile at a given price. The OAS method is more accurate than simply comparing a bond’s yield to maturity to a benchmark.

The OAS takes into account two types of volatility facing fixed-income investments with embedded options: changing interest rates (which affect all bonds) and prepayment risk. The shortfall of this approach is that estimates are based off of historical data, but are used in a forward-looking model. For example, prepayment is typically estimated from historical data, and does not take into account economic shifts or other changes that might occur in the future.

OAS is most likely to be used in the valuation of mortgage-backed securities. In this sense, the prepayment risk is the risk that the property owner may pay back the value of the mortgage before it is due. This risk increases as interest rates fall. A larger OAS implies a greater return for greater risks.

RELATED TERMS
  1. Risk-Free Rate Of Return

    The theoretical rate of return of an investment with zero risk. ...
  2. Workout Period

    The period of time when temporary yield discrepancies between ...
  3. Interest Only (IO) Strips

    The interest portion of mortgage, Treasury or bond payments, ...
  4. Kicker

    1. A right, exercisable warrant, or other feature that is added ...
  5. Sweetener

    A special feature or benefit added to a debt instrument (such ...
  6. Prepayment Risk

    The risk associated with the early unscheduled return of principal ...
Related Articles
  1. Bonds & Fixed Income

    Understanding Bond Prices and Yields

    Understanding this relationship can help an investor in any market.
  2. Options & Futures

    How Risk Free Is The Risk-Free Rate Of Return?

    This rate is rarely questioned - unless the economy falls into disarray.
  3. Bonds & Fixed Income

    Guide To Embedded Options In Bonds

    Investors should be aware of embedded options that may be available in certain securities as these options may affect the value of the security.
  4. Trading Strategies

    Beginner's Guide To Trading Fixed Income

    Beginner's Guide To Trading Fixed Income
  5. Bonds & Fixed Income

    The Impact Of An Inverted Yield Curve

    Find out what happens when short-term interest rates exceed long-term rates.
  6. Options & Futures

    Callable Bonds: Leading A Double Life

    Find out more about these dangerous and exciting cousins to regular bonds.
  7. Options & Futures

    Options Basics Tutorial

    Discover the world of options, from primary concepts to how options work and why you might use them.
  8. Bonds & Fixed Income

    Use Duration And Convexity To Measure Bond Risk

    Find out how this measure can help fixed-income investors manage their portfolios.
  9. Bonds & Fixed Income

    Bond Yield Curve Holds Predictive Powers

    This measure can shed light on future economic activity, inflation levels and interest rates.
  10. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
RELATED FAQS
  1. What are the most popular and useful measures of credit spread?

    The most popular and useful measures of the credit spread, also known as the yield spread, are the z-spread and the option-adjusted ... Read Full Answer >>
  2. Why do interest rates tend to have an inverse relationship with bond prices?

    At first glance, the inverse relationship between interest rates and bond prices seems somewhat illogical, but upon closer ... Read Full Answer >>
  3. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  4. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  5. What are the maximum Social Security disability benefits?

    The average Social Security disability benefit amount for a recipient of Social Security Disability Insurance (SSDI) in 2 ... Read Full Answer >>
  6. How do I calculate the future value of an annuity?

    When planning for retirement, it is important to have a good idea of how much income you can rely on each year. There are ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center