Abstract
The option-adjusted spread (OAS) is derived by positing an array of interest rate paths (using multinomial lattice or simulation techniques) consistent with the current Treasury term structure. These interest rate paths are then used to discount the cash flows from non-Treasury securities to arrive at present values. (We note here that the cash flows may depend upon the level, or even the history, of interest rates.) The present values are averaged to get an expected value, which can be viewed as the theoretically correct price of the security.
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