Option-Adjusted Duration

Option-adjusted duration and effective duration are closely related concepts and are often used interchangeably in practice, but the option-adjusted framing emphasizes the role of the OAS framework in the computation. The option-adjusted spread is the constant spread over the risk-free benchmark that equates a bond's model-computed theoretical value — treating embedded options explicitly — to its market price. Once the OAS is determined, the option-adjusted duration is computed by shifting the benchmark curve up and down by a small amount (holding OAS constant) and observing the resulting price changes.

The key insight is that by holding OAS constant across the rate scenarios, the option-adjusted duration isolates the pure interest rate sensitivity of the bond, net of credit and liquidity effects captured in the OAS. This is particularly important for mortgage-backed securities, where spreads over Treasuries reflect both credit/prepayment risk premium and interest rate sensitivity, making raw price sensitivity misleading as an interest rate hedge ratio.

For corporate callable bonds, option-adjusted duration will typically be lower than the duration to maturity but higher than the duration to the nearest call date when the call option is out of the money. As rates decline and the call option moves into the money — the bond is more likely to be called — option-adjusted duration contracts toward the call date duration, reflecting the increased probability of early redemption.

The option-adjusted framework also produces an option-adjusted convexity, which measures the curvature of the price-yield relationship after accounting for optionality. Negative option-adjusted convexity — common in mortgage-backed securities and in-the-money callable bonds — means the bond underperforms a non-callable bond of equal duration in both rising and falling rate environments, since price appreciation is capped when rates fall (calls get exercised) while price declines are not similarly cushioned when rates rise.

For institutional fixed income managers, option-adjusted duration is the preferred measure for instruments with embedded options, as it enables consistent comparison of rate sensitivity across a portfolio containing a mix of plain-vanilla Treasuries, agency mortgage-backed securities, corporate callable bonds, and other optionable instruments. Hedging based on raw or modified duration for such a portfolio would systematically mismeasure the actual interest rate risk.