Unlike the Z-spread calculation, the option-adjusted spread takes into account how the embedded option in a bond can change the future cash flows and overall value of the bond. Mortgage-backed securities often have embedded options due to the prepayment risk associated with mortgages. As such, the embedded option can have a significant impact on the future cash flows and present value of the mortgage-backed securities. The embedded option's cost is calculated as the difference between the option-adjusted spread at the expected interest rate and the Z-spread. The base calculations for both spreads are similar, while the option-adjusted spread discounts the bond's value since the option is callable.
The nominal spread is the most basic spread concept and measures the difference in the basis points between a risk-free Treasury debt instrument and a non-Treasury instrument. This spread difference is measured in basis points. The nominal spread only provides the measure at one point along the Treasury yield curve, which is a significant limitation.
The Z-spread provides the difference in basis points along the entire Treasury yield curve. The Z-spread is the constant spread that will make the bond's price equal to the present value of its cash flows along each point of maturity for the Treasury curve. Therefore, the cash flow is discounted at the Treasury spot rate, plus the Z-spread. However, the Z-spread does not include the value of embedded options in its calculation. Embedded options can impact the present value of bonds.
The option-adjusted spread adjusts the Z-spread to include the embedded option's value. The option-adjusted spread is therefore a dynamic pricing model that is highly dependent on the model being used. The option-adjusted spread considers the variability of interest rates and of prepayment rates. These factors' calculations are complex, since they attempt to model future changes in interest rates and prepayment behavior of mortgage borrowers. More advanced statistical modeling methods such as Monte Carlo analysis are often used to predict prepayment probabilities.
Mortgage-backed securities often include embedded options, since there is a significant risk of prepayment. Mortgage borrowers are more likely to refinance their mortgages if interest rates go down. The embedded option means the future cash flows are alterable by the issuer since the bond can be called. The embedded option may be used by the issuer if interest rates drop. The embedded call allows the issuer to call the outstanding debt, pay it off and reissue it at a lower interest rate. By being able to reissue the debt at a lower interest rate, the issuer can reduce the cost of capital.
Investors in bonds with embedded options therefore take on more risk. If the bond is called, the investor will likely be forced to reinvest in other bonds with lower interest rates. Bonds with embedded call options often pay a yield premium over bonds with similar terms. Thus, the option-adjusted spread is helpful to understand the present value of debt securities with embedded call options.