# Understanding Option-Adjusted Spread (OAS): Definition, Example, and Impact

## What Is Option-Adjusted Spread (OAS)?

The option-adjusted spread (OAS) measures the spread between a bond's rate and the risk-free rate, while adjusting for any embedded options like callables or mortgage-backed securities. Utilizing OAS helps investors determine the value and potential risks of investing by evaluating a bond’s yield against economic factors and market volatility.  

### Key Takeaways

*   The option-adjusted spread (OAS) is a measure used to compare the yield of bonds with embedded options against the risk-free rate of return.  
    
*   By analyzing securities separately as a bond and an embedded option, OAS provides a more accurate valuation than simply using yield to maturity.  
    
*   Embedded options like those in mortgage-backed securities can significantly affect a bond's cash flow, influencing its present value.  
    
*   OAS uses statistical modeling, such as Monte Carlo analysis, to estimate impacts on future cash flows and prepayment risks.  
    
*   Unlike the Z-spread, OAS includes the value of embedded options, making it a more dynamic and comprehensive pricing model.

![Option-Adjusted Spread (OAS): A way for investors to compare the yield of two different fixed-income offerings that have embedded options.](https://www.investopedia.com/thmb/KJWB205A35EHdhIfuyv8SE02Rpw=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/optionadjustedspread.asp-final-3cb5fb69311f4188b14d3064efba3163.png)

*— Investopedia / Zoe Hansen*

## In-Depth Look at Option-Adjusted Spread (OAS)

The option-adjusted spread helps investors compare a fixed-income security’s cash flows to reference rates while also valuing embedded options against general market volatility. By separately analyzing the security into a bond and the embedded option, analysts can determine whether the investment is worthwhile at a given price. OAS is more accurate than just comparing a bond's yield to a benchmark.

The option-adjusted spread considers historical data as the variability of interest rates and prepayment rates. These factors' calculations are complex since they attempt to model future changes in interest rates, prepayment behavior of mortgage borrowers, and the probability of early redemption. More advanced statistical modeling methods such as [Monte Carlo analysis](https://www.investopedia.com/terms/m/montecarlosimulation.asp) are often used to predict prepayment probabilities.

## How Options and Volatility Impact OAS

A bond's yield to maturity (YTM) is the yield on a benchmark security, which can be a Treasury security with a similar maturity plus a premium or spread above the risk-free rate to compensate investors for the added risk.

The analysis gets more complicated when a bond has embedded options. Call options let the issuer redeem the bond early at a set price, while put options let the holder sell back the bond on specific dates. The OAS adjusts the spread in order to account for the potential changing cash flows.

OAS considers two volatility factors for bonds with embedded options: changing interest rates and prepayment risk. A limitation is that OAS estimates rely on past data for predicting future trends. Prepayment is usually estimated from past data, without considering future economic shifts or changes.

## Comparing OAS and Z-Spread

The OAS should not be confused with a [Z-spread](https://www.investopedia.com/terms/z/zspread.asp). The Z-spread is the constant spread that makes the bond's price equal to the present value of its cash flow along each point along the Treasury curve. However, it does not include the value of the embedded options, which can have a big impact on the present value. The Z-spread is also known as the static spread because of the consistent feature.

The OAS effectively adjusts the Z-spread to include the [value of the embedded option](https://www.investopedia.com/ask/answers/052115/what-difference-between-optionadjusted-spread-and-zspread-reference-mortgagebacked-securities-mbs.asp). It is, therefore, a dynamic pricing model that is highly dependent on the model being used. Also, it allows for the comparison using the market interest rate and the possibility of the bond being called early—known as prepayment risk.

## OAS in Practice: An Example Using Mortgage-Backed Securities

As an example, [mortgage-backed securities](https://www.investopedia.com/terms/m/mbs.asp) (MBS) often have embedded options due to the prepayment risk associated with the underlying mortgages. As such, the embedded option can have a significant impact on the future cash flows and the present value of the MBS. OAS is therefore particularly useful in the valuation of mortgage-backed securities. In this sense, the prepayment risk is the risk that the property owner may pay back the value of the mortgage before it is due. This risk increases as interest rates fall. A larger OAS implies a greater return for greater risks.

## The Bottom Line

The option-adjusted spread (OAS) is a crucial tool for investors analyzing fixed-income securities with embedded options, such as mortgage-backed securities. By comparing these bonds' yields with the risk-free Treasury rates and adjusting for options, investors gain insights into the true value and risks associated with these instruments. Understanding OAS allows for better assessment of a bond's cash flow under varying interest rates and market conditions. This analysis, more comprehensive than using a standard yield-to-maturity comparison, helps investors make informed decisions regarding the potential returns and risks linked to option-embedded securities.