I'm struggling a little with the interpretation of option adjusted spread on mortgage backed securities. I can see how, for a corporate bond without optionality, the z-spread is sort of like a constant hazard rate of default.
- Is it right to think of OAS as the constant hazard rate of default on a corporate bond with optionality?
- Can I think of the z-spread on a corporate bond with optionality as a constant hazard of non-payment due to either default or option exercise? (I think this isn't quite right because in event of option exercise the principal is paid).
- Can I think of (z-spread - OAS) as a constant hazard rate of option exercise?
Underlying these questions is my confusion about what is being accomplished by including OAS in the different interest rate scenarios when modelling the option. In which states of the world is the option expected to be exercised? Is it those states when it is optimal to do so according to the scenario's zero-coupon rate? Or is it those states when it is optimal given zero-coupon rate plus OAS?
My next confusion is how OAS deals with the fact that the option isn't exercised exactly when it is optimal. For corporate bonds there is the issuer's cost of refinancing to consider.
- Is this, in fact, exactly why OAS is included in the scenarios for modelling the option -- it is reflecting the refinancing cost that prevents the issuer from refinancing?
On the other hand for RMBS there are numerous causes of prepayment including time-varying macro factors and behavioral factors.
- If the answer to #1 above is affirmative, then (a) does that interpretation also hold for agency RMBS which are guaranteed? and (b) if so, why isn't OAS just the same as the spread on an agency bond?
If the answer to #4 is affirmative, then by analogy it would seem for agency RMBS the OAS should capture all deviation of realistic mortgage prepayment (due to all causes) from purely optimal refinancing (ignoring house sales etc.) If that's right then the answer to 5(a) is "no". Maybe for a callable corporate bond the OAS represents the credit spread reflected in the price after adjusting for the value of the call option -- the spread the bond would have with the option stripped out. But for agency RMBS it's clearly not the spread on a hypothetical MBS where prepayment is stripped out because OAS would seem to go up when home owners are for some reason less likely to prepay and go down when for some reason home owners are more likely to prepay.
- Is there any intuitive interpretation of OAS on agency RMBS e.g. in terms of hazard rates, or as the spread on some hypothetical instrument?