"The option-adjusted spread measures the yield spread over the Treasury on-the-run yield curve." Explain why you agree or disagree with this statement

Question

What will be an ideal response?

Answer 1

As seen below, there are various ways to measure the option-adjusted yield spread. In terms of the option-adjusted spread (OAS), it measures the yield spread over the spot rate curve or benchmark used in the valuation. More details are supplied below.

In traditional yield spread analysis, an investor compares the yield to maturity of a bond with the yield to maturity of a similar maturity on-the-run Treasury security. This means that the yield to maturity of a 25-year zero-coupon corporate bond and an 8.8% coupon 25-year corporate coupon bond would both be compared to a benchmark 25-year Treasury security. Such a comparison makes little sense, because the cash flow characteristics of the two corporate bonds will not be the same as that of the benchmark Treasury.

The proper way to compare non-Treasury bonds of the same maturity but with different coupon rates is to compare them with a portfolio of Treasury securities that have the same cash flow. For example, consider the 8.8% 25-year corporate bond selling for 87.0798 . The cash flow per $100 par value for this corporate bond, assuming that interest rates do not change (i.e., assuming static interest rates), is 49 six-month payments of $4.40 and a payment in 25 years (50 six-month periods) of $104.40 . A portfolio that will replicate this cash flow would include 50 zero-coupon Treasury securities with maturities coinciding with the amount and timing of the cash flows of the corporate bond.

The option-adjusted spread (OAS) is a spread over the spot rate curve or benchmark used in the valuation. In the case of the binomial method, the OAS is a spread over the binomial interest-rate tree. Some market participants construct the binomial interest-rate tree using the Treasury spot rates. In this case the OAS reflects the richness or cheapness of the security, if any, plus a credit spread. Other market participants construct the binomial interest-rate tree from the issuer's spot rate curve. In this case the credit risk is already incorporated into the analysis, and the OAS therefore reflects the richness or cheapness of a security. Therefore, it is critical to know the
on-the-run issues that the modeler used to construct the binomial interest-rate tree.