PT - JOURNAL ARTICLE AU - Paul H Kupiec AU - Adama Kah TI - On the Origin and Interpretation of OAS AID - 10.3905/jfi.1999.319222 DP - 1999 Dec 31 TA - The Journal of Fixed Income PG - 82--92 VI - 9 IP - 3 4099 - https://pm-research.com/content/9/3/82.short 4100 - https://pm-research.com/content/9/3/82.full AB - OAS, or “option-adjusted spread,” a commonly quoted statistic in the mortgage-backed securities market, is a mathematical construct used to ensure that a mortgage's estimated equivalent martingale mode price is equal to is quoted market price. Absent any OAS adjustment, common risk-neutral mortgage pricing models fail to accurately predict mortgage market prices. As such. OAS is a particular approach to error correction. Pitfalls arise in the interpretation and use of OAS in portfolio management. A common but flawed interpretation holds that OAS measures the expected risk premium compensation for bearing prepayment risk. Our interpretation suggests that the existence of OAS is symptomatic of a misspecified prepayment model; OAS is not an estimate of an expected risk premium. The analysis shows that prepayment model error - a mean zero random innovation in prepayments - is also not a source of OAS, nor is OAS an estimate of the expected compensation for bearing the risk of prepayment model error.