THE BOND AS A PORTFOLIO
THIS CHAPTER BEGINS the discussion of option-adjusted spread (OAS) analysis by describing how it handles the early-redemption provisions of a bond. Unlike yield analysis, OAS analysis does not attempt to predict a bond’s likely redemption date. Instead, it treats a bond’s early-redemption provisions—whether puts, calls, sinking funds, or a combination of the three—as options on its cash flows. Since such provisions are built into the cash-flow structure of a bond, they are referred to as the embedded options of a bond. Specifically, the OAS model measures the issue’s spread, in basis points, relative to risk-free rates of return, after adjusting for the effects of any embedded options.
Embedded options do not ...