Option-adjusted spread analysis

The modified duration and convexity methods we have described are only suitable for use in the analysis of conventional fixed-income instruments with known fixed cash flows and maturity dates. They are not satisfactory for use with bonds that contain embedded options such as callable bonds or instruments with unknown final redemption dates such as mortgage-backed bonds. For these and other bonds that exhibit uncertainties in their cash flow pattern and redemption date, so-called option-adjusted measures are used. The most common of these is option-adjusted spread (OAS) and option-adjusted duration (OAD). The techniques were developed to allow for the uncertain cash flow structure of non-vanilla fixed-income instruments, and model the effect of the option element of such bonds. 

A complete description of option-adjusted spread is outside of the scope of this book here we present an overview of the basic concepts. An excellent in-depth account of this technique is given by Windas (1993). 

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. 

Thus the OAS is an indication of the value of the option element of the hond as well as the premium required by investors in return for accepting the default risk of the corporate bond. When OAS is measured as a spread between two bonds of similar default risk, the yield difference between the bonds reflects the value of the option element only. This is rare and the market convention is measure OAS over the equivalent benchmark government bond. OAS is used in the analysis of corporate bonds that incorporate call or put provisions, as well as mortgage-backed securities with prepayment risk. For both applications, the spread is calculated as the number of basis points over the yield of the government bond that would equate the price of both bonds. 

Thus OAS is a general stochastic model, with discount rates derived from the standard benchmark term structure of interest rates. This is an advantage over more traditional methods in which a single discount rate is used. The calculated spread is a spread over risk-free forward rates, accounting for both interest-rate uncertainty and the price of default risk. As with any methodol-ogy, OAS has both strengths and weaknesses however, it provides more realistic analysis than the traditional yield-to-maturity approach. Hence, it has been widely adopted by investots since its introduction in the late 1980s. 

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Kopprasch, R., 1994. Option-adjusted spread analysis going down the wrong path Financial Analysts Journal, 121-135. 

Windas, T., 1993. An introduction to option-adjusted spread analysis, first ed. Bloomberg Press. 

Windas, T. 1996. An Introduction to Option-Adjusted Spread Analysis. Princeton Bloomberg Press. 

As introduced in Chapter 8, the most suitable measure of return for bonds with embedded options is known as option-adjusted spread or OAS. In this chapter, we show the analysis of bonds with embedded options, with particular focus on pricing methodology. 

If a bond s actual redemption date differs from the assumed one, its return computed this way is meaningless. The market, therefore, prefers to use other methods to calculate the return of callable bonds. The most common method is option-adjusted spread, or OAS, analysis. Although the discussion in this chapter centers on callable bonds, the principles enunciated apply to all bonds with embedded options. 

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