Option-adjusted spread

"Trees" are widely applied in mathematical finance; here used in calculating an OAS. Other common pricing-methods are simulation and PDEs. These are used for settings beyond those envisaged by Black-Scholes. Post crisis, even in those settings, banks use local and stochastic volatility models to incorporate the volatility surface.

Option-adjusted spread (OAS) is the yield spread which has to be added to a benchmark yield curve to discount a security's payments to match its market price, using a dynamic pricing model that accounts for embedded options. OAS is hence model-dependent. This concept can be applied to a mortgage-backed security (MBS), or another bond with embedded options, or any other interest rate derivative or option. More loosely, the OAS of a security can be interpreted as its "expected outperformance" versus the benchmarks, if the cash flows and the yield curve behave consistently with the valuation model.

In the context of an MBS or callable bond, the embedded option relates primarily to the borrower's right to early repayment, a right commonly exercised via the borrower refinancing the debt. These securities must therefore pay higher yields than noncallable debt, and their values are more fairly compared by OAS than by yield. OAS is usually measured in basis points (bp, or 0.01%).

For a security whose cash flows are independent of future interest rates, OAS is essentially the same as Z-spread.