Fixed Income Securities III: Option-Adjusted Spread Analysis
The modified duration and convexity methods we have described are only suitable for use in the analysis of conventional fixed income instruments with known fixed cash flows and maturity date. They are not satisfactory for use with bonds that contain embedded options such as callable bonds, or instruments with unknown final redemption dates such as mortgage-backed bonds.1 For these and other bonds that exhibit uncertainties in their cash flow pattern and redemption date, so-called option-adjusted measures are used. The most common of these are option-adjusted spread (OAS) and option-adjusted duration (OAD). The techniques were developed to allow for the uncertain cash flow structure of non-vanilla fixed income instruments, and model the effect of the option element of such bonds.
KeywordsInterest Rate Cash Flow Default Risk Forward Rate Spot Rate
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Selected References and Bibliography
- Si Chen ‘Understanding option-adjusted spreads: the implied prepayment hypothesis’, Journal of Portfolio Management, Summer 1996, pp. 104–13.Google Scholar
- Wilson, R. and Fabozzi, F. The New Corporate Bond Market, Probus, 1990, ch. 11.Google Scholar
- Windas, T. An Introduction to Option-Adjusted Spread Analysis, Bloomberg, 1993.Google Scholar