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Option adjusted spread (OAS) is the flat spread over the treasury yield curve required to discount a mortgage-backed security's volatile coupon payments to match its market price. In finance the Yield spread is the difference between the quoted rates of return on two different investments; a way of comparing any two financial products. ...
Treasury Securities are bonds issued by the U.S. Treasury, and sold by the Federal Open Market Committee, or FOMC. They are the debt finance instruments of the Federal government, and are often referred to as treasuries. ...
The US dollar yield curve as at 9 February 2005. ...
In finance, discounting is the process of finding the current value of an amount of cash at some future date, and along with compounding cash form the basis of time value of money calculations. ...
A mortgage-backed security (MBS) is similar to a bond whose cash flows are backed by mortgage payments. ...
In economics and business, the price is the assigned numerical monetary value of a good, service or asset. ...
Definition In contrast to the simple "yield curve spread" measurement of bond premium over a pre-determined cash-flow model, the OAS describes the market premium over a model including two types of volatility: Yield curve spread on a simple Mortgage Backed Security is the flat spread over the treasury yield curve required in discounting a pre-determined coupon schedule to arrive at its present market price. ...
Volatility is the standard deviation of the change in value of a financial instrument with a specific time horizon. ...
Designing such models in the first place is complicated because prepayment variations are a behavioural function of the stochastic interest rate. (They tend to go up as IRs come down.) An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. ...
Prepayment is repayment (anticipation) of the total loan amount by a property owner whos mortgage is backing a Mortgage Backed Security (MBS). ...
Behavior (U.S.) or behaviour (U.K.) refers to the actions or reactions of an object or organism, usually in relation to the environment. ...
Stochastic, from the Greek stochos or goal, means of, relating to, or characterized by conjecture; conjectural; random. ...
OAS is an emerging term with fluid use across MBS finance. The definition here is based on Kakhir Hayre's Mortgage Backed Securities text book. Other definitions are rough analogs: Finance studies and addresses the ways in which individuals, businesses and organizations raise, allocate and use monetary resources over time, taking into account the risks entailed in their projects. ...
- Take the expected value (mean NPV) across the range of all possible rate scenarios when discounting each scenario's actual cash flows with the treasury yield curve plus a spread, X. The OAS is defined as the value of X equating the market price of the MBS to its value in this theoretical framework.
Treasury bonds may not be available with maturities exactly matching likely cash flow payments so some interpolation may be necessary to make this calculation. In probability theory (and especially gambling), the expected value (or mathematical expectation) of a random variable is the sum of the probability of each possible outcome of the experiment multiplied by its payoff (value). Thus, it represents the average amount one expects to win per bet if bets with identical...
Net present value is a form of calculating discounted cash flow. ...
In the mathematical subfield of numerical analysis, interpolation is a method of constructing new data points from a discrete set of known data points. ...
Convexity
The word 'Option' in Option adjusted spread relates to the right of property owners, whose mortgages back the MBS, to prepay the full mortgage amount. Since mortgage-payers will only tend to exercise this right when it is favourable for them and unfavourable for the bond-holder buying an MBS partly involves selling an option. This is the source of the option adjusted spread (OAS). Prepayment is repayment (anticipation) of the total loan amount by a property owner whos mortgage is backing a Mortgage Backed Security (MBS). ...
A mortgage is a method of using property as security for the payment of a debt. ...
In finance, an option is a contract whereby one party (the holder or buyer) has the right but not the obligation to exercise a feature of the contract (the option) on or before a future date (the exercise date or expiry). ...
Since prepayments rise as interest rates fall and vice versa the basic (pass-through) MBS has negative bond convexity (second derivative of price over yield). The MBS-holder's exposure to property-owner prepayment has several names: An interest rate is the price a borrower pays for the use of money he does not own, and the return a lender receives for deferring his consumption, by lending to the borrower. ...
In finance, convexity is a measure of the sensitivity of the price of a bond to changes in interest rates. ...
Yield may mean: In economics, yield is a measure of the amount of income an investment generates over time (related to return on investment). ...
- extension or contraction risk
- prepayment risk
- reinvestment risk (Kakhir Hayre's term)
This difference in convexity can also be used to explain the price differential from an MBS to a treasury bond. However, the OAS-figure is typically preferred. The discussion of the "negative convexity" and "option adjusted spread" on a bond is essentially discussion of a single MBS feature (prepayment risk) measured in different ways. Reinvestment risk is one of the main genres of financial risk. ...
See also - Convertible bonds must pay a similar increased yield (over the standard corporate bond) when they are callable by the issuing company.
- Monte Carlo techniques are used to derive the Option adjusted spread.
A convertible bond is type of bond that can be converted into shares of stock in the issuing company, usually at some pre-announced ratio. ...
Monte Carlo methods are a class of computational algorithms for simulating the behavior of various physical and mathematical systems. ...
References Hayre, L. 2001, Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities, Wiley ISBN 0471385875 2001: A Space Odyssey. ...
External Sites - OAS analysis using Monte Carlo with many power point examples (Deals with implying the OAS from the bond market prices. Estimate of minimum OAS = 150 basis points.)
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