Valuation Commentary

What is Behind OAS Measures?
by Alex Levin

While skimming the Divide and Conquer trilogy someone asked me: “You don’t like the OAS, do you?” The answer is, yes, we do like OAS and generally view it as an application of the option pricing theory. Our idea to replace the OAS measure with prOAS is a proposal not to rely solely on statistical prepayment models and to reflect their potential biases as well as market fears using so-called risk-neutral prepayments instead. Once this is done, the OAS methodology applies. Let us revisit the OAS concept, and provide its comprehensive power.

Defining the OAS rigorously

“OAS is a spread added to random discount rates generated by Monte-Carlo paths to equate averaged present value of contingent cash flows to true market price…” — does such a definition look familiar? It can be found in many textbooks and articles on MBS valuation, but sounds like a mathematical artifact having no economic meaning or financial consequence. What about usual callable bonds that are priced with OAS but without random simulations?

It does not surprise me that practitioners whose only knowledge of OAS is “some spread to plug in” don’t gain a deeper understanding and look for alternative measures, often reverting to the antiquated total return analysis. To them I can only exclaim, “OAS is total return!” The following two facts redefine OAS as a total return measure, expected or guaranteed.

Definition/Fact 1.OAS is equal to the expected return of a dynamic asset, adjusted for the interest rate risk minus the horizon-matching benchmark (risk-free) rate.

Suppose an MBS is priced off the LIBOR and has an OAS of 50 basis points. We want to assess the total return over a 1-yr horizon. If the 1-year LIBOR is, say, 3%, then our MBS is expected to return 3.5% on a risk-adjusted basis. Its actual return will be random but the mathematical expectation is known.

 

>>>