Definition/Fact 2. OAS is a guaranteed annualized earning of a perfectly hedged, perfectly funded dynamic asset.

This statement, unlike the previous one, guarantees the total return level under certain conditions. Suppose we fully fund and fully hedge the MBS in the previous example using LIBOR instruments. Then we will earn 50 bps of par annually, no matter what, for every interest rate scenario. Note that we did not add a word on risk adjustment in Definition/Fact 2. This is because a fully hedged portfolio is interest rate neutral and should bear no risk premium.

Between these two key facts, one can make rigorous return assessments in virtually any combination of investment situations. The only important binding constraint is that the model of randomness employed by an OAS model is adequate.

Question 1. Suppose someone starts a fund by investing in an asset that is fairly priced at 50 bp OAS to LIBOR. The asset is funded by 10% of one’s own capital with the rest of their position (90%) being fully funded via LIBOR borrowings and perfectly hedged. What can be said of the total return on equity (ROE) assuming a 1-year horizon and 3% of the LIBOR rate?

Question 2. Modify Question 1 assuming the fund is 100% hedged, keeping the same (10 + 90) borrowing structure.

Answers to these two questions can be found at the end of this article.

What does prOAS bring to the table?

Only an adjustment for prepay model risk. Hence, one can use prOAS in lieu of OAS in all statements above. “Risk-adjustment” and “perfect hedging” are now understood with respect to both usual interest rate risk and prepay model risk. Should we decide to further adjust for credit risk, we would do similarly, etc.

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