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
Famous quotes containing the word definition:
“Was man made stupid to see his own stupidity?
Is God by definition indifferent, beyond us all?
Is the eternal truth man’s fighting soul
Wherein the Beast ravens in its own avidity?”
—Richard Eberhart (b. 1904)
“Beauty, like all other qualities presented to human experience, is relative; and the definition of it becomes unmeaning and useless in proportion to its abstractness. To define beauty not in the most abstract, but in the most concrete terms possible, not to find a universal formula for it, but the formula which expresses most adequately this or that special manifestation of it, is the aim of the true student of aesthetics.”
—Walter Pater (1839–1894)
“Perhaps the best definition of progress would be the continuing efforts of men and women to narrow the gap between the convenience of the powers that be and the unwritten charter.”
—Nadine Gordimer (b. 1923)