Convexity
The word 'Option' in Option adjusted spread relates to the right of property owners, whose mortgages back the MBS, to prepay the full mortgage amount. Since mortgage-payers will only tend to exercise this right when it is favourable for them and unfavourable for the bond-holder, buying an MBS partly involves selling an option. This is the source of the difference between the option adjusted spread (OAS) and the Z-spread (which ignores embedded options).
Since prepayments rise as interest rates fall and vice versa, the basic (pass-through) MBS has negative bond convexity (second derivative of price over yield). The MBS-holder's exposure to property-owner prepayment has several names:
- extension or contraction risk
- prepayment risk
- reinvestment risk
This difference in convexity can also be used to explain the price differential from an MBS to a treasury bond. However, the OAS-figure is typically preferred. The discussion of the "negative convexity" and "option adjusted spread" on a bond is essentially a discussion of a single MBS feature (prepayment risk) measured in different ways.
Read more about this topic: Option-adjusted Spread