The zero-volatility spread and the option-adjusted (OAS) can be used to calculate the value of a security (Z-spread). The space represents the gap between the two values. If two fixed-income products have embedded options, the yield can be compared using the OAS and the Z-spread. Optional features built into some fixed-income instruments may allow the investor or the issuer to cancel the issue or redeem the bond early.
For this reason, embedded options are commonly included in mortgage-backed securities (MBS) to mitigate prepayment risk. There is a substantial possibility that the embedded choice will affect both the market price of the MBS and the cash flows it generates in the future.
A fixed-income instrument's yield or return is compared to the risk-free rate of return using an option-adjusted spread. If all risk dynamics were to be abolished, an investment could theoretically yield a return equal to the risk-free rate. According to most analysts, the risk-free rate of return is often determined by using U.S. Treasuries.
A nominal spread is the most basic measure of space. The distance is the difference in interest rates investors must pay to achieve the same rate of return as the risk-free U.S. Treasury debt instrument.
This spread is a percentage representing the difference between the two prices. The tiny space only offers the measure at one point on the Treasury yield curve is a significant drawback.
Contrast Option Spread
One way the option-adjusted spread deviates from the Z-spread is that it considers the effect that embedded options will have on future cash flows and the value of the bond. Each bond has its own set of provisions that determine who has the power to do what, such as whether or not the issuer or the investor can call the bond or exchange it for stock in the underlying company.
Subtracting the option-adjusted spread at the expected market interest rate from the Z-spread yields the price of the embedded option. All other calculations for both spaces are equal. If options are included in the issuance, the bond's value will be reduced by the option-adjusted spread. A savvy investor can use this technique to determine whether or not a fixed-income security premium is justified by the added flexibility it provides.
The OAS completes the Z-spread by including the value of the embedded option. It is a form of dynamic pricing, but one that is model-dependent. There is the option to evaluate the market interest rate and prepayment risk.
The option-adjusted spread accounts for the possibility of fluctuating interest and prepayment rates. Predicting future changes in interest rates, mortgage borrowers' prepayment patterns, and the possibility of early redemption are all factors that make this equation challenging to solve. More sophisticated statistical modeling approaches, such as Monte Carlo analysis, are required to estimate the likelihood of prepayment.
Z-Spread
When looking at the yield curve for Treasuries, the zero-volatility spread will reveal the difference in basis points at any given moment. The value of a bond can be estimated at each maturity date using the Z-spread, a standard method based on discounted cash flow. As a result, the bond's coupon payments are discounted at the current rate along the Treasury curve. A component of the complex calculation is the addition of the z-spread to the spot rate at a particular point on the turn. Embedded options can alter the present value of a bond, but the Z-spread ignores this value.
Because of the considerable prepayment risk, mortgage-backed securities often include embedded options. Homeowners are more likely to consider refinancing their mortgages if interest rates fall. Because of the embedded option, the issuer can influence the bond's future cash flows if the bond is called. The issuer can use the built-in option if interest rates fall. The issuer has the right to contact outstanding debt, pay interest, and issue new debt at a lower interest rate. Reissuing the debt at a lower interest rate reduces the issuer's cost of capital.
Investors in bonds with embedded options take on more danger by doing so. If bondholders have their bonds called, they may have to invest in bonds paying a lower interest rate. Bonds with call options often offer a higher yield than similar bonds without call options. The option-adjusted spread is a valuable tool for analyzing the present value of debt securities, including call options.