Option-Adjusted Spread (OAS)

AAA

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.

INVESTOPEDIA EXPLAINS '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. Prepayment Risk

    The risk associated with the early unscheduled return of principal ...
  2. Risk-Free Rate Of Return

    The theoretical rate of return of an investment with zero risk. ...
  3. Sweetener

    A special feature or benefit added to a debt instrument (such ...
  4. Swap Spread

    1. The difference between the negotiated and fixed rate of a ...
  5. Duration

    A measure of the sensitivity of the price (the value of principal) ...
  6. Embedded Option

    A provision in a security that is an inseparable part of the ...
Related Articles
  1. Understanding Bond Prices and Yields
    Bonds & Fixed Income

    Understanding Bond Prices and Yields

  2. How Risk Free Is The Risk-Free Rate ...
    Options & Futures

    How Risk Free Is The Risk-Free Rate ...

  3. Guide To Embedded Options In Bonds
    Bonds & Fixed Income

    Guide To Embedded Options In Bonds

  4. Beginner's Guide To Trading Fixed Income
    Trading Strategies

    Beginner's Guide To Trading Fixed Income

comments powered by Disqus
Hot Definitions
  1. Elasticity

    A measure of a variable's sensitivity to a change in another variable. In economics, elasticity refers the degree to which ...
  2. Tangible Common Equity - TCE

    A measure of a company's capital, which is used to evaluate a financial institution's ability to deal with potential losses. ...
  3. Yield To Maturity (YTM)

    The rate of return anticipated on a bond if held until the maturity date. YTM is considered a long-term bond yield expressed ...
  4. Net Present Value Of Growth Opportunities - NPVGO

    A calculation of the net present value of all future cash flows involved with an additional acquisition, or potential acquisition. ...
  5. Gresham's Law

    A monetary principle stating that "bad money drives out good." In currency valuation, Gresham's Law states that if a new ...
  6. Limit-On-Open Order - LOO

    A type of limit order to buy or sell shares at the market open if the market price meets the limit condition. This type of ...
Trading Center