The formula explained in the above paragraph enables the investor to compute the value of a bond with an embedded option as the difference between the value of an option-free bond and the value of the option-linked bond. But, bond market participants prefer to think in terms of yield spread measures rather than in terms of price differentials. A yield spread is the difference between the yield to maturity on a non-government bond and a government bond of comparable maturity.
The value of option-adjusted spread analysis enables investors to separate the embedded option and judge the degree to which an instrument's yield compensates them for credit risk, liquidity risk or other such factors. Suppose an investor is comparing two similar bonds. Both have similar maturities, credit qualities and liquidity, but they have different embedded options. The investor would purchase the bond that has higher option-adjusted spread, as that would offer higher compensation for the risks taken.
(OAS) is the spread at which it presumably would be trading over a benchmark if it had no embedded option. More precisely, it is the instrument's current spread over the benchmark minus that component of the spread which is attributable to the cost of the embedded options. OAS can be calculated with respect to various benchmarks such as treasuries, swap rates, a short-term "risk-free" rate, etc. Most often, the benchmark is Treasuries.
Option-adjusted spread = Spread - Option value (in interest rate basis points).
The nominal spread between the two yields reflects differences in,
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Credit risk.
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Liquidity risk.
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Option risk.
Suppose, if one of the issues is a non-Treasury issue with an embedded option and the interest rate of treasury on-the-run securities is taken as the benchmark, then the nominal spread is a measure of the difference due to the,
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Credit risk of the non-treasury issue,
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Liquidity risk associated with the non-treasury issue, and
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Option risk associated with the non-treasury issue that is missing in the treasury issues.
The purpose of calculating OAS is to remove the amount from nominal spread - the amount that is due to the option risk. This spread is known as option adjusted spread because it adjusts the cash flows for the option to the benchmark interest rates. Let us consider an issue with an OAS of 180 basis points for a callable bond of BBB industrial issue. This means that the OAS is the compensation for the credit risk and the lower liquidity of the industrial issue relative to the Treasury benchmark issues.
Now, if we consider bench mark interest rates to be the on-the-run interest rate for the issuer, then there is no difference in the credit risk between the benchmark interest rates and the non-treasury issue. This means, OAS reflects only the difference in the liquidity of an issue relative to the on-the-run issues. This process of valuation has removed the spread due to the option risk and also due to the credit risk by using the issuer's own benchmark interest rates.
Let us, instead of taking the issuer's interest rates as benchmark, consider the on-the-run issues for issuers in the same sector of the bond market and the same credit rating as our benchmark interest rates. For example, let us consider a callable issue of ABC manufacturing company, a BBB industrial company. An estimate can be made of the on-the-run yield curve. Using this curve, the OAS reflects the difference in the liquidity risk, the callable bond of the ABC manufacturing company and the on-the-run issue of the same company. But, when the bench mark interest rates are that of a generic BBB industrial company, the OAS reflects (1) the difference between the liquidity risk of the XYZ company's callable bond and that of a generic BBB industrial company and (2) the difference between event risk/credit risk specific to ABC manufacturing company's issue beyond generic BBB credit risk.
The various options one has with respect to the benchmark interest rates, which results in OAS capturing different risks, and thus the comparison of OAS values across global markets becomes difficult.
Of late, "funded" investors are using the London Interbank Offered Rate (LIBOR) as their benchmark interest rate. When the yield curve for LIBOR is used as the bench mark interest rate, the OAS reflects a spread relative to their funding cost. The OAS reflects credit risk associated with LIBOR and liquidity risk of the issue.