What is Option Adjusted Spread Duration?

Duration is a measure of estimating the price (market value) change in a bond given a change in interest rates. Effective duration is a byproduct of the option models that produce OAS and it accounts for ways that changes in interest rates have the potential to change a bond’s cash flows.

How is Option Adjusted Spread Duration calculated?

It uses hundreds of yield-curve scenarios to make the calculation. The formula looks like this: OAS = Z Spread – Embedded Option.

What is the effect of greater expected interest rate volatility on the option adjusted spread of a security?

If the interest rate volatility is higher, the likelihood of the option being exercised is higher (that’s why the option increases in value).

What are the limitations of the option adjusted spread measure?

Disadvantages of Option Adjusted Spread OAS model needs to be updated in case of any regime changes i.e. a shift in economic data in order to become responsive. Model dependent. Difficulty in interpretation can result in the distorted picture of the behavior of securities.

Why is Option Adjusted Spread important?

Understanding 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. The OAS method is more accurate than simply comparing a bond’s yield to maturity to a benchmark.

Is option adjusted duration the same as effective duration?

An alternative measure of duration – known as “option-adjusted duration” or “effective duration” – takes into account the effect of the call option on the expected life of a bond.

How is spread duration calculated?

Duration Times Spread (DTS) is the market standard method for measuring the credit volatility of a corporate bond. It is calculated by simply multiplying two readily available bond characteristics: the spread-durations and the credit spread.

What is spread duration of a bond?

Spread duration is the sensitivity of the price of a security to changes in its credit spread. The credit spread is the difference between the yield of a security and the yield of a benchmark rate, such as a cash interest rate or government bond yield.

How does interest rate volatility affect callable bonds?

From the above formula, we can conclude that as the value of the investor put option increases with the value of the straight bond being constant, the value of the putable bond also increases.

How interest rate volatility affects the value of a callable or putable bond?

Interest rate volatility is modeled using a binomial interest rate tree. The higher the volatility, the lower the value of the callable bond and the higher the value of the putable bond.

How does Option Adjusted Spread differ from zero volatility spread for callable bonds?

The Option Adjusted spread is simply the Z- Spread excluding the premium to compensate for the option risk. Thus, the OAS is the spread above the treasury curve that compensates for credit and liquidity risk only. Z-spread is the all-in spread, meaning spread from the risk profile AND from the call risk.

How does Option Adjusted Spread work?

The option-adjusted spread (OAS) is the measurement of the spread of a fixed-income security rate and the risk-free rate of return, which is then adjusted to take into account an embedded option. The spread is added to the fixed-income security price to make the risk-free bond price the same as the bond.