Option Adjusted Spreads

Definition of Option Adjusted Spreads

The option-adjusted spreads are defined as the mechanism used to measure the security’s performance deviation using the benchmark used for the embedded options. This mechanism is added to the benchmark yield curve to price security. Therefore, it is also called the yield curve, which is also used to determine the valuation of various complicated securities like mortgage-backed securities, collateral debt obligations, convertible debentures, and option-embedded bonds.

Explanation

Option-adjusted spreads use the probability theory for the valuation of the bond spread. This theory is the opposite of the “Yield-Curve spread” theory, in which a fixed cash flow model is used. Such a process is complicated and requires a lot of knowledge and technicality. However, once such a spread is achieved, it has many benefits in the long run.

Purpose of Option Adjusted Spreads

Different purposes are mentioned below:

• Many mechanisms use the benchmark yield curve for fixed cash flows. However, option-adjusted spreads are used for the securities that have embedded options. This mechanism is used because it is important to consider the interest rate fluctuations.
• It is also used in the collateralized mortgage obligation market and the amortization class tranches. The securities which have the long-term form the highest portion of the option-adjusted spreads.
• Many other models, like the binomial model, use several assumptions. However, option-adjusted spreads are preferred for securities that do not possess such assumptions.

Example of Option Adjusted Spreads

Mack wants to estimate the option-adjusted Spread of the seven years, 12% callable option with a face value of $2,000 and the present, the 189.6528 and the 10-year, 12% non-callable bond with a face value of $2,000, and a present value of 190.4589. Then, with the available figures, calculate a spread that can equate the prices of the two bonds.

Solution:

Spread can be calculated by first converting the differences between the market price and the fair price of each bond into the yield.

YTM of a callable bond is calculated as

YTM = ((Face value/Bond price) 1/Time period)-1

• YTM of callable bond = ((2000 / 189.6528) 1/ 10)-1
• YTM of callable bond = 5.456%

YTM of non-callable bond is calculated as

• YTM of non-callable bond = ((2000 /190.4589) 1/ 10)-1
• YTM of non-callable bond = 5.010%

Option-adjusted Spread is calculated as

Option-adjusted spread = YTM of callable bond – YTM of non-callable bond

• Option-adjusted spread = 5.456% – 5.010%
• Option-adjusted spread = 0.446%

Statement of calculation of Spread

Particulars	Value
Face value of a callable bond	2000
Face value of a non-callable bond	2000
Present value of the present value of a callable bond	189.653
Present value of a non-callable bond	190.459
Time period	10
YTM of a callable bond	5.46%
YTM of a non-callable bond	5.01%
Option-adjusted Spread	0.45%

Thus the option-adjusted Spread is 0.446%

How to Determine OAS?

Below are the steps for the determination of the OAS:

• First, the discounted cash flows are calculated using the prevailing interest rates of the particular securities.
• The sum of all the discounted cash flows is taken to calculate the theoretical value of the security. This theoretical value of the security also indicates the security’s market value.
• Many possible scenarios possess various interest rates; accordingly, the option-adjusted Spread is adjusted.
• Option-adjusted spreads consider various scenarios carrying several interest rate paths, and all these are added to the security yield curve. Finally, the cash flows are determined with all the paths, and the security price is determined.

Graph

Source- Ice Data Indices, LLC

The above graph shows ICE BofA Option-Adjusted Spreads (OAS) that are calculated spreads between the computed option-adjusted Spreads index of all the bonds in the given rating category and the spot Treasury curve. It presents the Spread from January 2006 to July 2020.

Advantages

Some of the major advantages are mentioned below:

• The option-adjusted Spread is considered reliable for the base calculation of other similar-natured security spreads.
• The estimation and the probability of the prepayment do not depend on the estimation; rather than that, it depends on the past performance of the security or the historical data.
• In the simulation process of the option-adjusted spreads, Monte Carlo analysis and similar models are used. These are the most reliable models; hence, the option-adjusted spreads simulation process is considered very reliable.
• The option-adjusted spreads help calculate and compute the security price with an embedded option.

Disadvantages

Some of the major disadvantages are as follows

• The Computation of the OAS is very complicated, and it is not that user-friendly. Therefore, one must possess good knowledge for such a complex computation and determination of the OAS.
• The implementation of the OAS is also very difficult to implement. These involve lots of technical and legal requirements, and these entire requirements take a good amount of time.
• If there is sometimes the wrong interpretation of the OAS, it can result in the wrong view of the security’s behavior.
• OAS is much more prone to the model risk, and this risk sometimes results in negative trends in returns.

Conclusion

It involves very complex calculations, and very sophisticated models are involved in their analysis; however, the OAS is a very effective analytical tool used to evaluate the embedded securities. If the OAS disadvantages are improved, these spreads can become more popular in the market, increasing their demand.

Recommended Articles

This is a guide to Option Adjusted Spreads. Here we discuss the definition and example of option-adjusted Spread along with its advantages and disadvantages. You may also look at the following articles to learn more –

1. Future vs Option
2. Stock Options
3. Put Options
4. Option Chain