What is Z-spread and option adjusted credit spread?
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Option-adjusted spread OAS is the yield spread which has to be added to a benchmark option adjusted spread investopedia curve to discount a security 's payments to match its market priceusing a dynamic pricing model that accounts for embedded options.
OAS is hence model-dependent. This concept can be applied to a mortgage-backed security MBSor another bond with embedded options, or any other interest rate derivative or option. More loosely, the OAS of a security can be interpreted as its "expected outperformance" versus the benchmarks, if the cash flows and the yield curve behave consistently with the valuation model. In the context of an MBS or callable bondthe embedded option relates primarily to the borrower's right to refinance the debt at a lower interest rate.
These securities must therefore pay higher yields than noncallable debt, and their values are more fairly compared by OAS than by yield. OAS is usually measured in basis points bp, or 0. For a security whose cash flows are independent of future interest rates, OAS is essentially the same as Z-spread. In contrast to simpler "yield-curve spread" measurements of bond premium using a fixed cash-flow model I-spread or Z-spreadthe OAS quantifies the yield premium using a probabilistic model that incorporates two types of volatility:.
Designing such models in the first place is complicated because prepayment rates are a path-dependent and behavioural function of the stochastic interest rate. They tend to go up as interest rates come down. Specially calibrated Monte Carlo techniques are generally used to simulate hundreds of yield-curve scenarios for the calculation. Option adjusted spread investopedia definitions are rough analogs:.
Treasury bonds or alternate benchmarks, such as the noncallable bonds of some other borrower, or interest rate swaps are generally not available option adjusted spread investopedia maturities exactly matching MBS cash flow payments, so interpolations are necessary to make the Option adjusted spread investopedia calculation. For an MBS, the word "Option" in Option-adjusted spread relates primarily to the right of property owners, whose mortgages back the security, to prepay the mortgage amount.
Since mortgage borrowers will tend to exercise this right when it is favourable for them and unfavourable for the bond-holder, buying an MBS implicitly involves selling an option. The presence of interest-rate caps can create further optionality.
The embedded "option cost" can be quantified by subtracting the OAS option adjusted spread investopedia the Z-spread which ignores optionality and volatility. Since prepayments typically rise as interest rates fall and vice versa, the basic pass-through MBS option adjusted spread investopedia has negative bond convexity second derivative option adjusted spread investopedia price over yieldmeaning that the price has more downside than upside as interest rates vary.
The MBS-holder's exposure to borrower prepayment has several names:. This difference in convexity can also be option adjusted spread investopedia to explain the price differential from an MBS to a Treasury bond. However, the OAS figure is usually preferred. The discussion of the "negative convexity" and "option cost" of a bond is essentially a discussion of a single MBS feature rate-dependent cash flows measured in different ways.
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