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Topic Title: What is Option Adjusted Spread analysis?
Created On Sun Mar 16, 03 09:33 PM

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Paul
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Sun Mar 16, 03 09:33 PM

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from mrbadguy

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montecarlo
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Sun Mar 16, 03 09:53 PM

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To start things off:

A measure of relative yield, usually on a risk-adjusted basis.

Most useful to compare fixed income instruments which have embedded instruments. Because, for example, a callable bond will have an inflated yield, it is meaningless to compare the yield of a callable to that of an option free bond. Also very useful when comparing mortgage back/asset backed securities which can have prepayment / option like characteristics.

Harryh
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Sun Apr 27, 03 06:01 PM

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OAS measure of yield has been introduced to accurately price callable bonds but is also used now as a measure for bullets yield.

1. For bullets, it is more accurate than YTM as 1. you use implied forward rates instead of the yield to maturity as a reinvestment rate
2. you discount using the zero cpn curve instead of the YTM
Even more, you calibrate your forward rates so that the PV of yor coupons match the market values

2. For callable and MBS, the YTM measure also assumes holding till maturity which is obviously inaccurate so the OAS uses binomial tree which takes into account the contingency of the future coupons.

The OAS is a constant spread to the whole discount curve you use ( e.g. treasury) which would result in a PV equal to the market price.

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volat
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Fri Jun 27, 03 08:31 AM

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Hi,
would be nice to see a simple example in a Excel for ex..
Thanks.

mrbadguy
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Wed Jul 30, 03 02:17 PM

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Volat, what about this, is it fitted?http://www.servicing.com/ips/HedgeSummaryReport.xls
rgds,

-------------------------
mrbadguy

pnowy
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Hm... mrbadguy... your link doesn't work :-(

mama
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Fri Feb 11, 05 11:46 AM

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Quote
Originally posted by: pnowy
Hm... mrbadguy... your link doesn't work :-(

Does anyone have more information OAS, for example using the binomial method. The only book I can find is Bloomberg's Windas book.

Thanks for any help.

nparaschos
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Fri Feb 11, 05 02:32 PM

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Try the fiollowing article: "A Model for Valuing Bonds and Embedded Options". Not much, but it's a start.

http://www.kalotay.com/research/

mama
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Mon Feb 14, 05 10:15 PM

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Quote
Originally posted by: nparaschos
Try the fiollowing article: "A Model for Valuing Bonds and Embedded Options". Not much, but it's a start.

http://www.kalotay.com/research/

Thanks. This was useful.

sofiger
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Thu Jun 23, 05 02:08 PM

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The xls spreadsheet link kindly posted below by mrbadguy does not work. Does any one have a spreadsheet example for calculating OAS? Thanks!

tbatson
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Wed Jul 06, 05 11:46 PM

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Just to add my "two cents" to this discussion. OAS is most commonly used with MBS's and Callable Bonds. Monte Carlo simulation is the most widely used approach with OAS. I have not seen a "binomial tree" used with OAS. Here's my definition of OAS from a mortgage loan perspective:

Option Adjusted Spread (OAS) - cash flows are generated from multiple forecasted coupon rate paths. These rate paths are randomly generated using Monte Carlo simulation. Prepayment rates vary along each rate path, according to various prepayment factors. The calculated multiple cash flow streams are discounted to produce multiple present values. The distributions of the present values are then averaged to calculate one average present value. A spread is added to the discount curve to equate present value with market value prices. This spread is known as OAS, which represents the average spread over the LIBOR(discount) curve that will be earned on the this security over the remaining life.

Edited: Wed Jul 06, 05 at 11:47 PM by tbatson

sofiger
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Thu Jul 07, 05 02:25 PM

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So, OAS approach is only used for ARMs?

tbatson
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Fri Jul 08, 05 01:39 AM

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Sofiger:

OAS can be used for adjustable and fixed rate securities. What is important about OAS is its use for securities with "embedded options" such as a callable bond or a mortgage, where the borrower has the option to payoff the loan.

Most securities are priced off the forward rate curve, but this does not always reflect the chances of rates suddenly declining and a callable bond being called or a mortgage being paid off, because of refinancing opportunities. By simulating different interest rate scenarios, using Monte Carlo, we can assign different probabilities to the present value of different cash flows. Properly simulating interest rates is a science in itself, and you can read about all these "1-factor", "2-factor", BGM, XYZ!!...models in this forum, but that's another story.

Here's a simplified example of OAS. Assume we have 7 diiferent interest rate scenarios: -300bp to +300bp, and a probability and market value of a hypothetical security has been assigned to each of these scenarios. Assume, also, that a spread of 2.75% was added to the discount curve to get these market values.

Shock Prob. MV
-3% 1% 103.65
-2% 5% 102.89
-1% 19% 101.49
0% 50% 99.72
+1% 19% 97.89
+2% 5% 95.90
+3% 1% 94.08

The expected value of this security is 99.66 (Sum of Prob. x MV). We then get a market quote for this security from a dealer, and he says its worth 102.75. Our discount curve is too high, so we lower the spread until are calculated value equals 102.75 (calibration). If we lower the spread to 2.02% over the discount curve(LIBOR), our new expected value is 102.75, which is equal to the value in the market today.

Shock Prob. MV
-3% 1% 106.02
-2% 5% 105.41
-1% 19% 104.42
0% 50% 102.84
+1% 19% 101.14
+2% 5% 99.36
+3% 1% 97.53

This 2.02% represents OAS (option adjusted spread). You can either think of OAS as a spread earned on this security over the LIBOR discount curve, or as an adjustment to make your calculated model value equal the current "market" value. Because different organizations use different models and assumptions, their OAS calculations will be different from one another.

sofiger
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Thu Jan 19, 06 11:04 PM

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Thank you tbatson! Your explanation is very helpful! Is excel capable of producing Monte Carlo simulations or I would need a MatLab?

I work for the CRE mortgage broker and what we do is estimating the discount rate through regressions based on historic trades. Our fixed rate models are pretty good and we are working on developing reasonable ARM models. We are leaning towards OAS.

cougar91
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Tue Apr 25, 06 06:52 PM

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sofiger,

Excel is very much capable of doing MC simulation, albeit at a slow speed as the # of simulation paths tick higher. It is good for just learning MC as a starting point, but not for doing real simulation of interest rate paths for OAS calculation. In addition to interest rate paths you have to use some type of prepayment model assumption, as there are a # of such models out there (CPR, PSA, etc.). Together they will decide prepayment rate and that is the likelihood of the option being exercised and then OAS can be tabulated.

If your company can afford it, I suggest the Salomon/Citigroup YieldBook. It's the best tool out there for doing this type of MBS OAS calculation. But it is not cheap so it maybe an overkill for you. Most users of this product are large FI shops like Blackrock and PIMCO.

http://www.yieldbook.com

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