What are the limitations of the option-adjusted spread measure?

Question

What will be an ideal response?

Answer 1

Although the OAS measure is much more useful than the static cash flow yield measure, it still suffers from major pitfalls. These limitations apply not only to the OAS for RMBS but also the OAS produced from a binomial model. First, the OAS is a product of the valuation model. The valuation model may be poorly constructed because it fails to capture the true factors that affect the value of particular securities. Second, in Monte Carlo simulation the interest-rate paths must be adjusted so that on-the-run Treasuries are valued properly. That is, the value of an on-the-run Treasury is equal to its market price or, equivalently, its OAS is zero. The process of adjusting the interest-rate paths to achieve that result is ad hoc.

A third problem with the OAS is that it assumes a constant OAS for each interest rate path and over time for a given interest-rate path. If there is a term structure to the OAS, this is not captured by having a single OAS number. Finally, the OAS is dependent on the volatility assumption, the prepayment assumption in the case of RMBS, and the rules for refunding in the case of corporate bonds.

In addition, there is a problem with calculating an OAS for a portfolio by taking a weighted average of the OAS of the individual portfolio holdings. Instead, if an OAS for a portfolio is sought, it is necessary to obtain the portfolio's cash flow along each interest-rate path. The OAS is then the spread that will make the average portfolio value equal to the portfolio's market value.