OAS Analysis and Effective Duration for MBS

A mortgage pass-through has an embedded prepayment option: the borrower can accelerate repayment at any time. This option has value — and it belongs to the borrower (the short party), not the investor. The option-adjusted spread (OAS) strips out the value of the embedded prepayment option and reports the residual spread the investor earns over the risk-free curve. An MBS with a nominal yield spread of 150 bps over Treasuries might have an OAS of only 80 bps once the option cost is removed — the other 70 bps compensates the investor for being short the prepayment option. OAS allows apples-to-apples comparison between MBS with different prepayment exposures, between MBS and corporate bonds, and between pass-throughs and CMO tranches. Computing OAS requires Monte Carlo simulation of interest rate paths, each with an associated prepayment response, making it computationally intensive but conceptually straightforward.