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. Kicker

    1. A right, exercisable warrant, or other feature that is added ...
  3. Embedded Option

    A provision in a security that is an inseparable part of the ...
  4. Yield Curve

    A line that plots the interest rates, at a set point in time, ...
  5. Workout Period

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

    The interest portion of mortgage, Treasury or bond payments, ...
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. Where can I find year-to-date (YTD) returns for benchmarks?

    Benchmarks are securities or groups of securities against which investment performance is analyzed. Examples of popular equity ... Read Full Answer >>
  4. What is the effective interest method of amortization?

    The effective interest method is an accounting practice used for discounting a bond. This method is used for bonds sold at ... Read Full Answer >>
  5. Under what circumstances would someone enter into a repurchase agreement?

    In finance, a repurchase agreement represents a contract between two parties, where one party sells a security to the other ... Read Full Answer >>
  6. What risks should I consider taking a short put position?

    The risks to consider before taking a short put position are the odds of sustained weakness in the asset price and a spike ... Read Full Answer >>
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. Savings

    Explaining Term Deposits

    A term deposit (more often called a certificate of deposit or CD) is a deposit account that is made for a specific period of time.

You May Also Like

Hot Definitions
  1. Social Security

    A United States federal program of social insurance and benefits developed in 1935. The Social Security program's benefits ...
  2. American Dream

    The belief that anyone, regardless of where they were born or what class they were born into, can attain their own version ...
  3. Multicurrency Note Facility

    A credit facility that finances short- to medium-term Euro notes. Multicurrency note facilities are denominated in many currencies. ...
  4. National Currency

    The currency or legal tender issued by a nation's central bank or monetary authority. The national currency of a nation is ...
  5. Treasury Yield

    The return on investment, expressed as a percentage, on the debt obligations of the U.S. government. Treasuries are considered ...
  6. Bund

    A bond issued by Germany's federal government, or the German word for "bond." Bunds are the German equivalent of U.S. Treasury ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!