The OAS is the option-adjusted spread. It is determined using a binomial tree where a spread (the OAS) is added to the benchmark yield to find the arbitrage-free value for the callable or putable bond. The arbitrage-free value is the imputed value equal to the current bond price. The OAS is referred to as an option-adjusted spread because the cash flows in the tree are adjusted to reflect the option of the bond (e.g. a callable bond’s price is capped at the call price when interest rates drop). The nominal spread is simply the bond’s yield minus the benchmark yield. The Z-spread is the spread that, when added to the spot rates from a yield curve, results in an imputed value equal to the bond’s current price. The nominal spread and the Z-spread do not adjust the cash flows for the bond’s option. Thus the calculated yield spread using both these measures will reflect the option risk in the bond, as well as the bond’s credit and liquidity risk. Because the OAS calculation adjusts the cash flows for the bond’s option-like characteristics, the calculated OAS is just a reflection of the bond’s credit and liquidity risk, relative to the benchmark spot rates. |
