Encyclopedia of Financial Models, 3 Volume Set

Understanding the Building Blocks for OAS Models

PHILIP O. OBAZEE

Senior Vice President and Head of Derivatives, Delaware Investments

Abstract: Ubiquity of option-adjusted spread (OAS) in finance practice is remarkable, in light of the fact that there is no general consensus on its implementation. Investors in mortgage-backed (MBS) and asset-backed (ABS) securities hold a long position in noncallable bonds and short positions in prepayment (call) options. The noncallable bond is a bundle of zero coupon bonds, and the call option gives the borrower the right to prepay the loan at any time prior to the scheduled principal repayment dates. The call option component of the valuation consists of intrinsic and time values. To the extent that the option embedded in ABS/MBS is a delayed American exercise style, the time value component associated with prepayment volatility needs to be evaluated. To evaluate this option, OAS analysis uses an option-based technique to price ABS/MBS under different interest rate scenarios. Hence, OAS is the spread differential between the zero volatility spread and option value components of an ABS/MBS.

Investors and analysts continue to wrestle with the differences in option-adjusted-spread (OAS) values for securities they see from competing dealers and vendors. And portfolio managers continue to pose fundamental questions about OAS with which we all struggle in the financial industry. Some of the frequently asked questions are

• How can we interpret ...