What is Option-Adjusted Spread (OAS)?
There are different interest rates used for different transactions in the financial market. One popular rate is option-adjusted spread (OAS), which can be interpreted as a measure of MBS returns indicating potential compensation after adjusting for prepayment risk. We can also refer to the OAS as option-adjusted because the cash flows on the interest rate paths consider the borrowers’ Option to prepay. It can be expressed as the excess of the expected MBS return over the return on Treasuries.
Example of Option-Adjusted Spread (OAS):
Coming up with the right OAS is always a challenge, and many steps can be followed to derive the OAS, which are as follows:
Step 1: Perform a preliminary OAS estimate.
Step 2: Perform a Monte Carlo simulation using a discount rate equal to the sum of the Treasury rate and an OAS estimate.
Step 3: Compare the computed price in Step 2 to the market price.
Step 4: If the market price is higher (lower) than the simulated price, decrease (increase) the OAS estimate.
Step 5: Continue the iterative process by adjusting the OAS estimate to make the simulated and market prices identical.
For example, in Step 3, assume that the value of the MBS is determined to be 98.55, but the market price is 97.70.
In that instance, the OAS is the incremental spread added to the previously determined discount rates that would force the price down from 98.55 to 97.70, done in steps 4 and 5.
Why is Option-Adjusted Spread (OAS) important?
MBS is considered one of the most pivotal products in the financial market. OAS assists organisations in predicting the rates well and managing the financial cash flows and related risks in a more efficient manner.