kickthatcfa

Say you buy a security with a coupon of 40 paid every 6 months for four years callable at 100 after two years and there is a downward sloping yield curve,

the yield on a treasury with same maturity is 3% so the nominal spread is 5% and the z-spread will be greater than the nominal because of the downward sloping yield curve so lets say the z-spread is 6%

However since the bond will probably be called in two years because of the the downward sloping yield curve you will receive your principal in two years and no interest. These forgone payments of interest and early return of principal have a value representing the cost of the option. When this cost is deducted from the z-spread you have the OAS spread.


People say that the OAS spread "does not reflect the option cost" because it is the spread on the payments that you are expected to receive given the structure of interest rates therefore it can be used to compare a security with an option to securities with different or no options. OAS essentially represents the spread on the payments you are expected to receive while z-spread is the spread if all payments are received.