The term embedded option refers to an option included in financial instruments that provides the issuer or holder with a right to perform some actions at a future time. However, this right does not obligate the issuer or holder to do so. Embedded options can be a part of financial securities, including stocks and bonds.
Investors can use the nominal spread to measure the difference between the yield of the bond and the yield to maturity of similar treasury bonds. However, the same does not apply when embedded options are a part of the bond. Instead of using the nominal spread, investors can use the option-adjusted spread.
What is the Option Adjusted Spread?
The option-adjusted spread measures the spread of a fixed-income instrument and the risk-free rate of return. Subsequently, it adjusts this spread to account for the embedded option. Simply put, it converts the difference between a fixed-income security’s market and fair price into yield. After that, it calculates a spread to make both of these prices equal.
Option-adjusted spread is common in mortgage-backed securities as they usually carry an embedded option. This option exists to hedge the prepayment risk associated with the mortgage. Analysts can adjust the risk-free rate to the embedded option. By doing so, they can calculate the expected cash flows and the present value of the mortgage-backed securities and how they may fluctuate.
How does the Option Adjusted Spread work?
The option-adjusted spread is crucial in helping investors evaluate embedded options against general market volatility. As mentioned, these apply to all bonds that carry an embedded option. This spread represents the spread after adjusting for the embedded option. That is how it gets its name. With option-adjusted spreads, investors can evaluate how the embedded option affects the bond and its value.
Embedded options may exist in various bonds. However, they create additional risks. For investors, looking at the option-adjusted spread for a bond can indicate whether they should invest in it. It also helps them evaluate whether the bond is worth the given price after accounting for the risks. Therefore, option-adjusted spreads can play a substantial role in determining the value of bonds with embedded options.
How to calculate the Option Adjusted Spread?
Investors looking to calculate the option-adjusted spread can do so by using the option-adjusted spread formula. This formula considers the difference between the Z-spread and the embedded option cost. Therefore, it will be as below.
Option adjusted spread = Z-spread – Option cost
What are the advantages and disadvantages of Option Adjusted Spread?
There are several advantages of the option-adjusted spread. Most importantly, it allows investors to separate bonds from their embedded option. It can help investors decide whether an investment is worthwhile. Similarly, it provides investors with an accurate picture of embedded option contracts. Overall, it can be substantial in helping investors calculate a security’s price that includes an embedded option.
However, there are some disadvantages that come with the option-adjusted spread. This spread uses advanced modes like Monte Carlo analysis in simulation. However, it may make the calculations much more complex. Similarly, it is prone to model risk and can distort investors’ perception of how bonds behave if calculated inaccurately.
Conclusion
Embedded options may exist in financial instruments. These options provide one party with a right to perform some specific actions at a specific time. However, these may carry some risks. Therefore, investors will need to calculate the option-adjusted spread. This spread measures the value of a bond by removing the cost of the embedded option from it.
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