Module 36.4 LOS 36.g: Calculation and use of OAS

One flaw of using backward induction in the risk-free binomial model is that if we use risk-free rates to model corporate debt, our values will be too high. The option adjusted spread (OAS) is a constant spread that is added to one-period rates in order match the market value of a risky asset with its binomial model value.

OAS is used by analysts in relative valuation; bonds with similar credit risk should have the same OAS. If the OAS for a bond is higher than the OAS of its peers, it is considered to be undervalued and hence an attractive investment (i.e., it offers a higher compensation for a given level of risk). Conversely, bonds with low OAS (relative to peers) are considered to be overvalued. If a bond has a negative OAS, it can be considered overvalued as well.

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