Option adjusted spread (OAS) is the flat spread over the treasury yield curve required to discount a security payment to match its market price. This concept can be applied to mortgagebacked security (MBS), option, bond and any other interestrate derivative. 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.
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In contrast to the simple "yield curve spread" measurement of bond premium over a predetermined cashflow model, the OAS describes the market premium over a model including two types of volatility:
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:
Treasury bonds may not be available with maturities exactly matching likely cash flow payments so some interpolation may be necessary to make this calculation.
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 mortgagepayers will only tend to exercise this right when it is favourable for them and unfavourable for the bondholder, buying an MBS partly involves selling an option. This is the source of the option adjusted spread (OAS).
Since prepayments rise as interest rates fall and vice versa the basic (passthrough) MBS has negative bond convexity (second derivative of price over yield). The MBSholder's exposure to propertyowner prepayment has several names:
This difference in convexity can also be used to explain the price differential from an MBS to a treasury bond. However, the OASfigure 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.

