Option-adjusted Spreads Research Articles

Explaining Credit Spread Changes: Some New Evidence from Option-Adjusted Spreads of Bond Indices

We examine the question of the determinants of corporate bond credit spreads using both weekly and monthly option-adjusted spreads for nine corporate bond indexes from Merrill Lynch from January 1997 to July 2002. We find that the Russell 2000 index historical return volatility and the Conference Board composite leading and coincident economic indicators have significant power in explaining credit spread changes, especially for high yield indexes. Furthermore, these three variables plus the interest rate level, the historical interest rate volatility, the yield curve slope, the Russell 2000 index return, and the Fama-French [1996] high-minus-low factor can explain more than 40% of credit spread changes for five bond indexes. In particular, these eight variables can explain 67.68% and 60.82% of credit spread changes for the B- and the BB-rated indexes, respectively. Our analysis confirms that credit spread changes for high-yield bonds are more closely related to equity market factors and also provides evidence in favor of incorporating macroeconomic factors into credit risk models.

An Econometric Model of Credit Spreads with Rebalancing, ARCH and Jump Effects

In this paper, we examine the dynamic behavior of credit spreads on corporate bond portfolios. We propose an econometric model of credit spreads that incorporates portfolio rebalancing, the near unit root property of spreads, the autocorrelation in spread changes, the ARCH conditional heteroscedasticity, jumps, and lagged market factors. In particular, our model is the first that takes into account explicitly the impact of rebalancing and yields estimates of the absorbing bounds on credit spreads induced by such rebalancing. We apply our model to nine Merrill Lynch daily series of option-adjusted spreads with ratings from AAA to C for the period January, 1997 through August, 2002. We find no evidence of mean reversion in these credit spread series over our sample period. However, we find ample evidence of both the ARCH effect and jumps in the data especially in the investment-grade credit spread indices. Incorporating jumps into the ARCH type conditional variance results in significant improvements in model diagnostic tests. We also find that while log spread variations depend on both the lagged Russell 2000 index return and lagged changes in the slope of the yield curve, the time-varying jump intensity of log credit spreads is correlated with the lagged stock market volatility. Finally, our results indicate the ARCH-jump specification outperforms the ARCH specification in the out-of-sample, one-step-ahead forecast of credit spreads.

Explaining Credit Spread Changes: Some New Evidence from Option-Adjusted Spreads of Bond Indices

Explaining Credit Spread Changes: Some New Evidence from Option-Adjusted Spreads of Bond Indices

Random Error in Prepayment Projections

Described here is a relatively simple model for incorporating random errors in projected prepayments into mortgage-backed securities valuation. The model involves specifying the correlation between month-to-month errors and the volatility of a noise term. These parameters in turn determine the likely duration of deviations between acual and projected prepayment speeds and the scale of the deviations. Random errors generally have little impact on option-adjusted spreads, investors should be concerned about systematic rather than random errors.

Understanding Option-Adjusted Spreads

Understanding Option-Adjusted Spreads

Pitfalls in the Analysis of Option-Adjusted Spreads

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.

Understanding option-adjusted spreads and their use

Understanding option-adjusted spreads and their use

Citicorp's mortgage valuation model: Option-adjusted spreads and option-based durations

Citicorp's mortgage valuation model combines a description of interest rate dynamics and a prepayment model together with a theory of security pricing to produce a measure of valuation called the option-adjusted spread (OAS). The OAS can be used to determine mispricing across both coupons and MBS programs, e.g., GNMA and FNMA, because it is free of the option cost.