Chartered Financial Analyst (CFA) Practice Exam Level 2

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What does Option Adjusted Spread (OAS) reflect?

The standard deviation of bond yields.
The difference between the Z spread and option value.
The total expected return minus the risk-free rate.
The yield spread adjusted for credit risk.

The correct answer is: The difference between the Z spread and option value.

Option Adjusted Spread (OAS) is a critical measure in fixed income analysis that reflects the additional yield that investors earn over a benchmark yield curve, specifically adjusted for the value of embedded options in a bond. This key aspect is captured through the difference between the Z spread, which measures the spread over the benchmark yield curve, and the cost or value of the options embedded in the bond, such as calls orputs. When calculating OAS, the options embedded in the bond are considered, and their value is subtracted from the Z spread. This results in a cleaner measure of the yield spread that an investor can expect to receive, net of option-related risks. This is essential for accurately assessing the risk-adjusted performance of fixed income securities that come with such features. In this context, the calculation of OAS allows investors to better understand the compensation they receive for taking on additional risks associated with these options, giving a clearer picture of the bond's underlying value. Other options either do not capture this specific adjustment for options or focus on broader concepts that do not address the relationship reflected by OAS.