Definition
In contrast to the simple "yield curve spread" measurement of bond premium over a pre-determined cash-flow model, the OAS describes the market premium over a model including two types of volatility:
- Variable interest rates
- Variable prepayment rates.
Designing such models in the first place is complicated because prepayment variations are a behavioural function of the stochastic interest rate. (They tend to go up as interest rates come down.)
OAS is an emerging term with fluid use across MBS finance. The definition here is based on Lakhbir Hayre's Mortgage Backed Securities text book. Other definitions are rough analogs:
- Take the expected value (mean NPV) across the range of all possible rate scenarios when discounting each scenario's actual cash flows with the treasury yield curve plus a spread, X. The OAS is defined as the value of X equating the market price of the MBS to its value in this theoretical framework.
Treasury bonds may not be available with maturities exactly matching likely cash flow payments so some interpolation may be necessary to make this calculation.
Read more about this topic: Option-adjusted Spread
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