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FRM Part I · FRM Exam Part I · Mortgages and Mortgage-Backed Securities

A analyst values an MBS using Monte Carlo simulation of interest-rate paths and finds the Z-spread over the Treasury spot curve is 120 bps, while the option-adjusted spread (OAS) is 70 bps. Which conclusion is most appropriate?

The prepayment option costs the investor roughly 50 bps, and the 70 bps OAS is the spread left after stripping out that option cost. OAS equals the Z-spread minus option cost, so 120 − 70 = 50 bps. It is built for securities with embedded options.

  1. AThe embedded prepayment option costs the investor about 50 bps of spread, and the OAS is the spread remaining after removing that option costCorrect
  2. BThe OAS exceeds the Z-spread because simulated paths add credit risk compensation
  3. CThe 50 bps difference is the agency guarantee fee deducted by the servicer
  4. DThe OAS should be ignored because it is only meaningful for non-callable bonds

Explanation

OAS = Z-spread − option cost, so the option cost is 120 − 70 = 50 bps. The OAS is the spread after removing the value of the borrowers' prepayment option. The second option reverses the relationship; OAS is designed precisely for bonds with embedded options.

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