Option-adjusted spread (OEA) is a benchmarking measure that calculates the difference in price between securities with embedded options and those without. It is used to price mortgage products with prepayment options and is calculated from a benchmark, such as LIBOR. OEAs are a proxy for option prices and higher margins imply higher risk.
An option-adjusted spread, also known as an OEA, is a measure used to determine the value of embedded options in the market. It is the difference between the price of a security with embedded options and the price of the same security without options. The option-adjusted spread is considered a benchmarking measure that allows traders and investors to measure the difference in price between similar securities with embedded options.
Option-adjusted spreads are often used to price mortgage products that have built-in options for the mortgage holder, such as prepayment options. The prepayment option allows the borrower the right to pay off the mortgage in full before it is due, which reduces the amount of interest the lender will receive over the life of the mortgage. Therefore, it is of value to the borrower to have the option to prepay the entire loan balance sooner. The difference in price between a mortgage that has this prepayment option and one that does not is considered the adjusted margin for the option.
The adjusted margin for options is generally calculated from a benchmark, which may be the average mortgage rate, treasury rates, exchange rates, or the London Interbank Offered Rate (LIBOR). It is calculated by taking the difference between the performance of option-based security versus the benchmark. For example, if the current price of a 30-year Treasury note is 6.5 percent and the current price of a 30-year mortgage with prepayment options is 7.0 percent, the adjusted margin for options is 0.5 percent, which is calculated by subtracting 6.5 from 7.0 .
To better understand what an option-adjusted spread is, it is important to understand what a derivative is. Derivatives and options are two terms that are often used interchangeably, but an option is actually a type of derivative. Derivatives are financial instruments that derive their value from other assets or securities in the market. For example, a “call option” on a particular stock is the right to buy the stock at a certain price in the future. It derives its value from the underlying asset, which is the stock itself. That is why options fall under the umbrella of derivatives.
In more practical and perhaps useful terms, option-adjusted spreads are used as a proxy for the option price. Market prices are based on a number of factors, including supply and demand. Therefore, it is difficult to determine the exact price of options, especially if they are embedded in another security. In general, the higher the option-adjusted spread, the higher the performance of the security in the market. However, it is important to note that higher option-adjusted margin also implies higher risk.
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