Option Adjusted Spread Strips Out the Part of a Yield You Will Not Keep
When a bond contains an embedded option, its quoted spread overstates the compensation. OAS removes the option value and leaves the part that reflects credit.
The Problem It Solves
Compare two bonds from the same issuer, same maturity. One is a straight bond quoted at 150 basis points over Treasuries. The other is callable and quoted at 220.
The callable one looks better by 70 basis points. It is not, or at least not by that much, because part of that yield is payment for an option the holder has sold rather than compensation for credit risk.
Comparing them on quoted spread is comparing an apple to an apple with a liability attached. Option adjusted spread, or OAS, is the correction.
What OAS Means
OAS is the spread over the risk free curve that remains after the value of the embedded option has been removed. Roughly: quoted spread minus option cost equals OAS.
If the call option in that bond is worth 90 basis points a year, the OAS is 130. Against the straight bond's 150, the callable is now the worse deal, which is the opposite of the surface reading.
The quoted spread tells you what the bond yields. The OAS tells you what you are being paid for credit risk, which is the only part you keep in every scenario.
How It Is Computed
The option value cannot be looked up, so it is modelled. The standard approach generates a large number of possible interest rate paths, consistent with today's yield curve and a volatility assumption. Along each path, the model decides whether the option would be exercised, using a call rule for corporates or a prepayment model for mortgages.
Each path produces a set of cash flows, discounted back at the path's rates plus a constant spread. That spread is adjusted until the average present value across all paths equals the market price. The spread that achieves it is the OAS.
The mechanism matters less than what it implies: the answer is only as good as the volatility assumption and the exercise model feeding it.
The Volatility Dependence
| Assumed volatility | Option value | Resulting OAS |
|---|---|---|
| Low | Small | Higher, bond looks attractive |
| High | Large | Lower, bond looks poor |
This is the practical caution. Two desks can compute a materially different OAS on the same bond by feeding in different volatility assumptions, and neither is wrong in an obvious way. An OAS quoted without reference to the volatility used is an incomplete number.
The dependence also means OAS moves when volatility moves, even with credit and rates unchanged. A spike in rate volatility raises the modelled option value and mechanically lowers reported OAS across the callable universe.
Where It Is Essential
Mortgage backed securities are the main application. Because the prepayment option is embedded in every underlying loan, nominal spread on a mortgage security is close to meaningless. OAS is the standard basis for comparison, and prepayment model quality is a genuine competitive differentiator among mortgage investors.
It matters equally for callable corporates, putable bonds where the holder holds the option and OAS exceeds the quoted spread, and any structure with an embedded contingency.
What It Still Misses
OAS isolates the option, not everything else. It does not separate liquidity from credit, so an illiquid bond shows a wide OAS that has nothing to do with default probability. It assumes the exercise model reflects real behaviour, which for mortgages means assuming households behave as they did historically.
When behaviour shifts, as it did when the rate lock in effect suppressed moving activity after 2022, the models were calibrated on a world that had changed.
The Bottom Line
Option adjusted spread removes embedded option value from a quoted spread so that bonds with different structures can be compared on credit alone. It is indispensable for mortgages and callables, and it is a model output rather than a market observation. Always ask what volatility assumption produced it, because that single input can move the answer more than the credit ever will.