The Z-spread (aka, zero-volatility OAS) for a mortgage-backed security (MBS) is 190 basis points. The option-adjusted spread (OAS) is 80 basis points. The OAS was generated with an assumption that the interest rate volatility is 18%. Which is nearest to the cost of the implied, embedded option in the MBS?
A. 92 bps
B. 110 bps
C. 128 bps
D. 172 bps
Answer: B
Option cost = zero-volatility OAS - OAS = Z-spread - OAS
In this case, option cost = 190 - 80 = 110 bps.