Schweser is somewhat confusing with regards to the OAS. On page 84 book 5 they give an example of calculating the OAS. In this example they figure out the spread which must be ADDED to the nodes in order to force the theoretical value of the bond down to market price. To me this in counter intuituve, sureley what they are doing there is calculating the option cost? The OAS is supposed to be the spread to the Treasury curve that the bond would have if it were option FREE ?!
Wikipedia also state that the OAS is an add on spread. If this is the case then how can the OAS be the 50bp spread in the example on page 84? Stating that the total spread was the Z spread and that the 50 point additional spread was the option cost would seem to make more sense? That way the Z pread - OAS = option cost would hold. Option-adjusted spread From Wikipedia, the free encyclopedia (Redirected from Option Adjusted Spread) Jump to: navigation, search Option adjusted spread (OAS) is the flat spread over the treasury yield curve required to discount a security payment to match its market price. This concept can be applied to mortgage-backed security (MBS), Options, Bonds and any other interest-rate Derivative.
Just seems counterintuitive to discount back to something that is inclusive of the option cost (e.g. the market price of the callable bond) with a spread which doesn’t include the cost of the option (e.g. OAS)
OK so i figured it out… here is an excellent article from Lehman of all people! http://www.classiccmp.org/transputer/finengineer/[Lehman%20Brothers,%20Pedersen]%20Explaining%20the%20Lehman%20Brothers%20Option%20Adjusted%20Spread%20of%20a%20Corporate%20Bond.pdf
OAS is the spread you have to add to each spot rate to equate the theoretical price to the market price. The OAS is a spread that does not include the option cost. The z-spread is a spread that does include option cost. zspread - option cost = OAS