Option-adjusted spread (OAS)

[Tedphy]

I have trouble understand the following statement from page 19 of R24.P1.T3.Tuckman_v5.0.pdf.

I hope you could give more context around the relative value, model value and model price below.

"
Option-adjusted spread (OAS) is a widely-used measure of the relative value of a (MBS)
security, that is, of its market price relative to its model value.

• OAS is defined as the spread such that the market price of a security equals its model price when discounted values are computed at risk-neutral rates plus (OAS) spread."

Thanks,
Ted

 

[QuantMan2318]

I don't know why, when I prepared for Part 1, Tuckman's readings were the most esoteric and challenging,
I don't know of a very specific answer to this one as I don't have any experience in the MBS markets, however, I will try to throw some light on this that I understood from the GARP material.

As you already know, a spread is a difference between 2 rates ( say the selling and buying rates ), here what I presumed was that we use a model to value MBS, let's assume that that model does not take into account the prepayments from the mortgage, so the actual Market price will differ from the model value by the prepayment rate as well as other factors, the OAS captures this difference so that when we discount the Market price at the Rf rate plus OAS spread we get the model price. So we can say that Market rate+-OAS spread in basis points gives the model rate.

So again I am assuming that the Model value/price of a security + OAS is relative value and that is mostly equal to the market value.

I do sincerely apologize if I am wrong and I beg some one with more knowledge to throw light on this. I only wanted to reply to this as no one else had replied and was curious to check if my understanding was correct. Please feel free to correct me

Regards
Mani

 

[Tedphy]

I don't know why, when I prepared for Part 1, Tuckman's readings were the most esoteric and challenging,
I don't know of a very specific answer to this one as I don't have any experience in the MBS markets, however, I will try to throw some light on this that I understood from the GARP material.

As you already know, a spread is a difference between 2 rates ( say the selling and buying rates ), here what I presumed was that we use a model to value MBS, let's assume that that model does not take into account the prepayments from the mortgage, so the actual Market price will differ from the model value by the prepayment rate as well as other factors, the OAS captures this difference so that when we discount the Market price at the Rf rate plus OAS spread we get the model price. So we can say that Market rate+-OAS spread in basis points gives the model rate.

So again I am assuming that the Model value/price of a security + OAS is relative value and that is mostly equal to the market value.

I do sincerely apologize if I am wrong and I beg some one with more knowledge to throw light on this. I only wanted to reply to this as no one else had replied and was curious to check if my understanding was correct. Please feel free to correct me

Regards
Mani

Hi Mani,

Thanks for your reply.

I think OAS does not include the spread for prepayment option. In other words, OAS only has spread for credit risk, liquidity risk, etc. Market price for MBS with embedded prepayment option I think it should be OAS + spread of prepayment option.

Thanks,
Tedphy

 

[QuantMan2318]

I think OAS does not include the spread for prepayment option. In other words, OAS only has spread for credit risk, liquidity risk, etc. Market price for MBS with embedded prepayment option I think it should be OAS + spread of prepayment option.

Well I took that conclusion from Tuckman's reading in the GARP book, he says
"to the extent that the model correctly accounts for the scheduled cash flows and repayments, the OAS is the deviation of the security's market price from the fair value" that means in this case OAS does not incorporate the prepayment option as you have rightly pointed out.
However he continues and says "to the extent that the model does not correctly account for the prepayments, the OAS will be a blend of relative value and leftout factors"-from this I came to the conclusion as in my earlier post

 

[Tedphy]

Well I took that conclusion from Tuckman's reading in the GARP book, he says
"to the extent that the model correctly accounts for the scheduled cash flows and repayments, the OAS is the deviation of the security's market price from the fair value" that means in this case OAS does not incorporate the prepayment option as you have rightly pointed out.
However he continues and says "to the extent that the model does not correctly account for the prepayments, the OAS will be a blend of relative value and leftout factors"-from this I came to the conclusion as in my earlier post

Thanks for your explanation.

Tedphy

 

[David Harper CFA FRM]

Interesting discussion! I would say that that OAS--as a spread--does not directly include "compensation" for prepayment (option) risk; but is sensitive to (or aware of) variability in prepayment risk. Going back to the definition: the OAS is the spread we add to all nodes on a binomial interest rate tree. This is the improvement of OAS over Z-spread: the Z-spread is over a single risk-free rate curve; the OAS is a spread over a tree (i.e., several) risk-free rate paths. A key purpose of the interest rate paths (the binomial tree) is to account for prepayments (e.g., at lower rates --> higher bond prices --> the callable bond will be exercised), so the interest rate tree accounts for the expected prepayment dynamic. Further, here the fundamental Fabozzie formula applies: value of callable bond = value of option-free bond - value of call option; i.e., greater interest rate volatility in the tree implies higher call option value and lower callable bond value. Once this "option-adjusted" tree is constructed, the OAS is the spread that, when added to all nodes, equates the binomial-generated-model price to the observed market price.

So @QuantMan2318 statements make a lot of sense in this context. We might assume that the interest rate true accurate reflects prepayment risk; e.g., at lower rates, the bond is called. In which case, as the model already correctly includes option risk, the OAS spread will not reflect compensation for prepayments, but issue specific (credit) risk and technical factors (liquidity). Thanks,

 

[QuantMan2318]

Beautiful David! That so much expanded my horizons

 

[td]

Is the following statement accurate. ..OAS is the present value of the required investor risk premium for uncertainty not associated with prepayment. As this certainty grows so does OAS.

OAS does account for some effects associated with interest rate volatility and prepayment since these are model based, probabilistically weighted outcomes.

 

[QuantMan2318]

OAS is the present value of the required investor risk premium for uncertainty not associated with prepayment. As this certainty grows so does OAS.
OAS does account for some effects associated with interest rate volatility and prepayment since these are model based, probabilistically weighted outcomes.

Can you tell me where you got the above from? The second line seems to be correct but the first line seems to be a bit dubious. Shouldn't it be "As uncertainty grows so should OAS?"

 

[td]

its a typo. it should say "un"certainty . I came up with the first line. I am not sure whether OAS is an exact representation of the pv of the required investor risk premium but it is certainly correlated with this factor. is there anything in particular that makes you dubious?

If you calculate the (Option Adjusted) duration after applying OAS, what is OAS's conceptual impact on the monthly cash flows? Does discounting by OAS compensate investors for default risk, making the investors indifferent between the MBS and treasure bonds?