Adjustable rate mortgages

The U.S. market also includes adjustable-rate mortgages, or ARMs, which reset interest payments at specified intervals to a specified shortterm interest rate index. The interval between resets can be a month, six months, a year, or longer. The interest rate is usually set at a spread over the reference rate, which can be market-determined—the prime rate, for instance—or calculated based on the funding costs for U.S. savings and loan institutions, or thrifts, as indicated by one of the thrift indexes. The two most commonly consulted thrift indexes are the Eleventh Federal Home Loan Bank Board District Cost of Funds Index, or COFI, and the National Cost of Funds Index. 

Waldman, M., and S. Modzelewski. 1985. A Framework for Evaluating Treasury-Based Adjustable Rate Mortgages. In Fabozzi, E, ed. The Handbook of Mortgage-Backed Securities. New York Probus Publishing. 

This relationship can be observed when yield spreads on current-coupon mortgages widen during declines in interest rates. As the possibility of prepayment increases, the cost of the bonds option feature rises put another way, the option feature gets closer to being in the money. To adjust for the increased value of the option, traders price higher spreads into the bond, which keeps the OAS more or less unchanged. 

Option-adjusted spread analysis uses simulated interest rate paths as part of its calculation of bond yield and convexity. Therefore an OAS model is a stochastic model. The OAS refers to the yield spread between a callable or mortgage-backed bond and a government benchmark bond. The government bond chosen ideally will have similar coupon and duration values. 

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