Option-Adjusted Spread (OAS)
The prime objective of an investor is to buy securities which have values greater than their market prices. The discussion made on the above valuation helps to arrive at a reasonably correct value of the bonds. Analyzing further, there is an opportunity to convert the divergence between the price observed in the market for the security and the value derived from the model into a yield spread measure. It appears convenient to the investors to compare the yields rather than the prices of bonds. Thus the yield spread measure comes very handy for the investor in taking decisions.
The Option-Adjusted Spread (OAS) is a measure of the yield spread (expressed in basis points) which can be used to convert differences between the values and the prices. It is thus basically used as a tool to reconcile value with market price. Since the cash flows of the callable bonds are adjusted to reflect the embedded option, the resulting spread is called option adjusted spread.
We have now observed that OAS is calculated using the valuation model. Working out in the reverse, it is possible to calculate the theoretical value for a given OAS. The assumed interest rate volatility affects the OAS as well as the theoretical value. The higher the expected interest rate volatility, the lower the OAS. Similarly the lower the expected interest rate volatility, the higher the OAS.