Dynamic Option Adjusted Spread and the Value of Mortgage Backed Securities (Draft 1)

Mario Cerrato and Abdelmadjid Djennad

No 2008-02, SIRE Discussion Papers from Scottish Institute for Research in Economics (SIRE)

Abstract: We extend a reduced form model for pricing pass-through mortgage backed securities (MBS) and provide a novel hedging tool for investors in this market. To calculate the price of an MBS, traders use what is known as option-adjusted spread (OAS). The resulting OAS value represents the required basis points adjustment to reference curve discounting rates needed to match an observed market price. The OAS suffers from some drawbacks. For example, it remains constant until the maturity of the bond (thirty years in mortgage-backed securities), and does not incorporate interest rate volatility. We suggest instead what we call dynamic option adjusted spread (DOAS). The latter allows investors in the mortgage market to account for both prepayment risk and changes of the yield curve.

Keywords: Asset pricing; Mortgage Backed Securities; Term Structure (search for similar items in EconPapers)
Date: 2008
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