What does the option-adjusted spread (OAS) actually tell me, and how is it different from the Z-spread?
CFA Level I introduces OAS as a way to compare bonds with embedded options. I understand that the Z-spread is the constant spread added to the Treasury spot curve to price a bond, but I'm confused about how OAS differs and when to use each.
The OAS vs. Z-spread distinction is one of the most important conceptual points in Level I fixed income. The key insight is about separating credit spread from option cost.
Z-Spread (Zero-Volatility Spread):
- A single constant spread added to each Treasury spot rate to make the PV of the bond's cash flows equal its market price
- Does NOT account for the value of any embedded option
- For option-free bonds: Z-spread = OAS (no option to adjust for)
OAS (Option-Adjusted Spread):
- The spread after removing the value of the embedded option
- Represents the compensation for credit risk and liquidity only
- Comparable across bonds with different option features
The Relationship:
For a callable bond (investor is short the call):
Z-spread = OAS + Option Cost
OAS = Z-spread - Option Cost
For a putable bond (investor is long the put):
Z-spread = OAS - Option Cost
OAS = Z-spread + Option Cost
Example:
Two bonds from Granite Financial Corporation:
- Bond A: Callable, Z-spread = 180 bps, Option cost = 45 bps
- Bond B: Non-callable, Z-spread = 160 bps, Option cost = 0 bps
OAS of Bond A: 180 - 45 = 135 bps
OAS of Bond B: 160 - 0 = 160 bps
Despite Bond A having a higher Z-spread (180 > 160), its OAS is lower (135 < 160). Bond B actually offers better compensation for credit and liquidity risk. Bond A's higher Z-spread is just compensating investors for the call option they've sold to the issuer.
When to Use Each:
| Situation | Use |
|---|---|
| Comparing option-free bonds | Z-spread is fine |
| Comparing callable to non-callable | Must use OAS |
| Comparing callable to putable | Must use OAS |
| Assessing pure credit compensation | Use OAS |
Exam Tip: If asked to identify the bond with the best value, always compare OAS, not Z-spread, when embedded options differ. A common trap is selecting the bond with the highest Z-spread without adjusting for option cost.
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