An option-adjusted spread, also referred to as OAS, is a measure used to determine the value of embedded options on the market. It is the difference between the price of a security with embedded options and the price of the same security without options. The option-adjusted spread is considered a benchmarking measure which allows traders and investors to measure the price difference between similar securities with embedded options.
Option-adjusted spreads are often used to price mortgage products that have embedded options to the mortgage holder, such as prepayment options. The prepayment option allows the borrower the right to pay the entire amount of the mortgage before it is due, which reduces the amount of interest the lender will receive over the life of the mortgage. Therefore, there's value to the borrower in having the option to prepay the entire loan balance earlier. The difference in price between a mortgage that has this prepayment option and one that does not is considered the option-adjusted spread.
The option-adjusted spread is usually calculated off of a benchmark, which can be the average mortgage rate, treasury rates, swap rates, or the London Interbank Offer Rate (LIBOR). It is calculated by taking the difference between the yield on the option-based security against the benchmark. For instance, if the current price for a 30-year treasury bond is 6.5 percent and the current price for a 30 year mortgage with prepayment options is 7.0 percent, the option-adjusted spread is 0.5 percent, which is calculated by subtracting 6.5 from 7.0.
In order to better understand what an option-adjusted spread is, it is important to understand what a derivative is. Derivatives and options are two terms which are often used interchangeably, but an option is actually a type of derivative. Derivatives are financial instruments which derive their value from other assets or securities in the market. For instance, a "call option" on a particular stock is the right to buy the stock at a certain price in the future. It derives its value from the underlying asset, which is the stock itself. This is why options fall under the umbrella of derivatives.
In more practical and perhaps useful terms, option-adjusted spreads are used as a proxy for the option price. Market prices are based on a host of factors, including supply and demand. It is therefore difficult to determine the exact price of options, especially if they are embedded in another security. In general, the higher the option-adjusted spread, the greater the return on the security in the market. It is important to note, however, that a higher option-adjusted spread also implies greater risk.