Option Adjusted Spread Risk

[rahul.goyl]

Hi David,

This look easy one, but need strong justification. Plz help with this one.

The option adjusted spread (OAS) is used to analyze risk by adjusting for the embedded options. Which of the following risks does the OAS reflect?
A)Prepayment risk.
B)Inflation risk.
C)Credit risk.
D)Maturity risk.

Regards,
Rahul

 

[hsuwang]

I think OAS is to reflect the prepayment risk premium... nominal spread reflects risk premium associated with the bond's risk (which includes prepayment risk), and OAS specifically address the amount of prepayment risk premium... I think..

 

[David Harper CFA FRM]

...I agree with Jack. From Fabozzi (p 881):

"The implied cost of the option [i.e., the prepayment option] embedded in any mortgage-backed security can be obtained by calculating the difference between the OAS at the assumed volatility of interest rates and the static spread. That is, Option cost = static spread − option-adjusted spread.

The reason that the option cost is measured in this way is as follows: In an environment of no interest-rate changes, the investor would earn the static spread. When future interest rates are uncertain, the spread is less, however, because of the homeowner’s option to prepay; the OAS reflects the spread after adjusting for this option. Therefore, the option cost is the difference between the spread that would be earned in a static interest-rate environment (the static spread) and the spread after adjusting for the homeowner’s option."

David

 

[frm_daniel]

Hi David,

I have some confusion about OAS .

Quoted “The implied cost of the option [i.e., the prepayment option] embedded in any mortgage-backed security" The implied option cost also refers to the prepayment option.

I understand (IMO, not sure)

1. OAS is the compensation for difference in credit and liquidity risks between the valued instrument and the benchmark interest rates

2. OAS does not compensate for is the option risk, because this risk was already recognized in the nodal decisions on the interest rate tree.

3 Therefore, option Cost (in terms of yield) = Zero Volatility Spread (i.e. static spread) – Option Adjusted Spread. The equation defines option cost as the static spread less option adjusted spread and this is to confirm my understanding in 2.

Daniel