Following is a definition picked from Exam Review - Question 100 of pg 37 book II. but schweser notes also says OAS is “option cost” and below says it also captures credit and liquidity risk (but not option risk). confusing. Any take on succinct/coherent definition The OAS provides a method of valuing the yield differential of certain fixed income securities versus Treasury securities with similar maturities. The OAS represents the higher yield of a non-Treasury security that compensates the investor for some amount of credit and liquidity risk. The OAS, by definition, excludes any compensation for the risk related to the embedded option. This broker’s OAS model has calculated that for this issue, the investor should receive 75 bps over a comparable Treasury security for the assumption of the additional credit and liquidity risk. The embedded option will increase the yield further, thus creating a total spread that is more than 75 bps
The option adjusted spread is the tool used to ‘convert’ an orange to apple: so that you can compare apples to apples. Imagine you are considering two bonds. The first is option-free (“the orange”) yielding 7%, and the other is a callable bond (“the apple”) yielding 8%. Hencey, you’re not comparing apples to apples. The callable bond will always have to yield a higher amount because it has a higher required rate of return, due to the fact that the bond owner demands to be compensated for the risk. So, in this case, the option-adjusted spread takes into consideration the excess yield a over a option-free bond and makes it comparable. Hence, the name, option adjusted spread. The opposite would be true for a putable bond, since investors are willing to accept a lower yield in exchange for the ability to ‘put’ the bond. Hope that helps.