Option-Adjusted Spread
The Option-Adjusted Spread (OAS) is the credit spread of a bond with embedded options — such as a callable or mortgage-backed security — after stripping out the value of those options, giving a purer measure of the bond's credit and liquidity premium over Treasuries.
Many bonds carry embedded options that distort their raw yield spreads. A callable bond gives the issuer the right to redeem the bond early, which benefits the issuer at the bondholder's expense; that optionality must be removed from the spread calculation to compare fairly with non-callable bonds. Mortgage-backed securities contain prepayment optionality — homeowners can refinance or pay off their mortgages at any time — creating a complex options profile that varies with interest rate levels.
OAS is calculated using interest rate models that simulate many possible future rate paths. For each path, the bond's cash flows are projected (accounting for how the embedded option would likely be exercised under those rate conditions), and the spread that equates the modeled present value to the market price is identified. The OAS is the constant spread added to all discount rates across all simulated paths that makes the modeled price equal the observed market price.
In practice, the OAS strips out option cost so that two bonds — one callable, one non-callable — can be compared on equal footing. A callable bond might show a nominal spread of 180 basis points over a matched Treasury, but if the call option is worth 40 basis points, the OAS is only 140 basis points. That 140 basis points is the compensation purely for credit and liquidity risk.
For agency mortgage-backed securities (MBS), OAS is the dominant spread metric used by portfolio managers and traders at major US banks and investment firms. The option cost in MBS is called the prepayment option, and modeling it requires sophisticated prepayment models that take into account interest rate levels, borrower equity, seasonality, and demographic factors. OAS levels for agency MBS are tracked closely as indicators of MBS valuation relative to Treasuries.
The limitation of OAS is model dependence: different rate models and prepayment assumptions produce different OAS values for the same bond. Comparing OAS across dealers or data sources requires ensuring the same modeling assumptions are used.