VanillaOption_Adjusted_Spread

The *VanillaOption Adjusted Spread* - abbreviated as *OAS* - is the spread added to the risk-free discounting rate in order to produce the effective rate, which is then used in the context of a particular interest rate model to discount the cash flows of the associated financial product, so that the calculated net present value equals the market price.

The above definition implies that the *OAS* is *a)* model-dependent and *b)* does not reflect features such as imbedded interest rate options, since these are already accounted for by the applicable model.

For example, let's assume we are trying to price a callable bond using a one-factor gaussian interest rate model and a particular yield curve supplying the risk-free discount factors.

Since our model incorporates the stochastic nature of the interest rates, the effect of the call right on the bond's price is captured - at least approximately - by the model and thus the calculated bond price should reflect the callability nature of the bond.

Nevertheless it is likely that the calculated price still differs from the actual market price by a certain amount.

The deviation can be due to several factors that our model fails to properly account for, such as default risk, liquidity premium, model risk etc.

The *OAS* is then simply the spread that we must add to the risk-free discounting rate - as the latter is used within our model in the process of the npv computation - in order to produce a calculated price that perfectly matches the observed market price.

The *OAS* can be very usefull in comparing two instruments that differ on the type of interest rate options imbedded in them, such as a callable bond versus a normal bond.

A significant difference in their *OAS* could then be an indication of a possible mispricing of one or both of the bonds.