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Explain how option-adjusted spreads are computed and what they are used for

CFA® Level II · Fixed Income · Valuation and Analysis of Bonds with Embedded Options · L2.FI.3.g

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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