Fixed Income
Understanding Option-Adjusted Spread (OAS)
When fixed-income instruments become more complex, simple yield comparisons stop working. A callable bond, a putable bond, or a mortgage-backed security does not behave like a plain vanilla bond. The embedded options change cash flows, and once that happens, spreads such as the nominal spread or Z-spread no longer tell the full story. This is where option-adjusted spread comes into the picture.
Option-adjusted spread tries to isolate the part of a bond’s yield that comes purely from credit and liquidity risk, after removing the effect of embedded options.
What Option-Adjusted Spread Really Means
Option-adjusted spread is the spread added to the risk-free yield curve that makes the option-adjusted price of a bond equal to its market price.
In simpler terms, OAS answers this question:
After adjusting for the value of embedded options, how much extra spread is the bond offering over risk-free rates?
Unlike other spreads, OAS does not treat cash flows as fixed. It recognises that cash flows may change depending on interest rate movements.
Why OAS Is Needed
For bonds without options, cash flows are known in advance. In such cases, spreads like Z-spread work well.
For bonds with embedded options, cash flows depend on future interest rates and issuer or borrower behaviour. A callable bond may be redeemed early. A mortgage borrower may prepay. These possibilities distort simple spread measures.
OAS removes this distortion by explicitly modelling the option feature and separating it from the bond’s underlying spread.
How OAS Is Calculated Conceptually
The calculation of OAS is model-based.
First, an interest rate model is used to generate multiple interest rate paths.
For each path, the bond’s cash flows are adjusted based on how the embedded option would behave.
The present value of these cash flows is calculated across all paths.
The OAS is the constant spread that makes the average present value equal to the observed market price.
Exams usually test the concept rather than the mathematics.
OAS Versus Z-Spread
This comparison appears frequently.
The Z-spread assumes fixed cash flows and adds a constant spread to every point on the spot curve.
The OAS adjusts cash flows first and then calculates the spread.
For option-free bonds, OAS and Z-spread are usually similar.
For bonds with embedded options, OAS is the more meaningful measure.
Understanding why they differ is more important than memorising definitions.
Interpretation of OAS
A higher OAS indicates that the bond offers more compensation for credit and liquidity risk, after accounting for options.
When comparing two bonds with similar option features, the one with the higher OAS is generally considered more attractive, assuming similar risk profiles.
OAS is best used as a relative measure, not as a standalone signal.
Application in Mortgage-Backed Securities
OAS is especially important for mortgage-backed securities.
Prepayment options embedded in mortgages significantly affect cash flows. When interest rates fall, borrowers refinance. When rates rise, prepayments slow.
OAS allows analysts to compare mortgage-backed securities with different prepayment characteristics on a more consistent basis.
This application is commonly tested in CFA and FRM exams.
Limitations of Option-Adjusted Spread
OAS depends heavily on the interest rate model used. Different models can produce different OAS values for the same security.
Prepayment assumptions may also change over time, especially in stressed markets. As a result, OAS should be interpreted with caution and updated regularly.
Exams may test awareness of this model risk rather than calculation detail.
Common Exam Confusions
Students often confuse OAS with Z-spread and assume both measure the same thing.
Another common mistake is applying OAS to bonds without embedded options unnecessarily.
Some candidates also forget that OAS is model-dependent, while Z-spread is not.
Being clear on these distinctions helps avoid easy errors.
Final Thought
Option-adjusted spread is designed for situations where cash flows are uncertain due to embedded options. By separating option value from credit and liquidity spread, OAS provides a cleaner comparison across complex fixed-income instruments. For exam preparation, the focus should be on understanding why OAS exists, how it differs from other spreads, and where it is most appropriately applied. Once this intuition is clear, OAS questions become far more manageable.
