Abstract
OAS, or “option-adjusted spread,” a commonly quoted statistic in the mortgage-backed securities market, is a mathematical construct used to ensure that a mortgage9s estimated equivalent martingale mode price is equal to is quoted market price. Absent any OAS adjustment, common risk-neutral mortgage pricing models fail to accurately predict mortgage market prices. As such. OAS is a particular approach to error correction. Pitfalls arise in the interpretation and use of OAS in portfolio management. A common but flawed interpretation holds that OAS measures the expected risk premium compensation for bearing prepayment risk. Our interpretation suggests that the existence of OAS is symptomatic of a misspecified prepayment model; OAS is not an estimate of an expected risk premium. The analysis shows that prepayment model error - a mean zero random innovation in prepayments - is also not a source of OAS, nor is OAS an estimate of the expected compensation for bearing the risk of prepayment model error.
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