Explain how option-adjusted spreads are computed and what they are used for
The idea
The option-adjusted spread is the constant spread which, added to every rate in a calibrated tree, makes the model value of a bond with options equal to its market price. It measures compensation for credit and liquidity risk after the embedded option has been valued and removed. For a callable bond, the Z-spread, which ignores the option, exceeds the OAS, and the difference is the option cost in spread terms; for a putable bond the OAS exceeds the Z-spread. Among bonds of similar credit quality, a higher OAS suggests the bond is cheap and a lower OAS suggests it is rich. Do not compare a Z-spread on one bond with an OAS on another.
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Take the free diagnostic →More in Valuation and Analysis of Bonds with Embedded Options
- Explain bonds and other debt securities that contain embedded options
- Explain how a callable or putable bond's value links to the value of its embedded option and of the equivalent straight bond
- Explain how to apply the arbitrage-free approach when valuing a bond that contains embedded options
- Explain the effect of interest rate volatility on what a callable or putable bond is worth
- Explain the effect of shifts in the yield curve's level and shape on what a callable or putable bond is worth
- Use an interest rate tree to work out what a callable or putable bond is worth
- Explain the effect of interest rate volatility on option-adjusted spreads
- Work out a callable or putable bond's effective duration and explain what it means
- Contrast the effective durations of straight, callable and putable bonds
- Explain how one-sided and key rate durations help assess the rate sensitivity of bonds that contain embedded options
- Contrast the effective convexities of straight, callable and putable bonds
- Work out what a floating-rate bond with a cap or a floor is worth
- Set out the key characteristics of a convertible bond
- Work out the parts that make up a convertible bond's value and explain what they mean
- Explain how to value a convertible bond within an arbitrage-free framework
- Weigh the risk and return profile of a convertible bond against the profiles of a straight bond and the underlying common shares