Option-adjusted duration and convexity [market]
AIM: Define option-adjusted duration, option adjusted convexity and simulated average life.
- Option cost embedded in MBS:
- Option cost = static spread – OAS
- Option-adjusted duration (a.k.a., effective duration)
- Bond is re-priced (shock up & shock down) holding OAS constant but shifting term structure
- Effective duration incorporates cash flow changes caused by yield shifts
- Option-adjusted convexity: similarly, assumes that cash flows change when yields change (unlike “regular” convexity)
- Simulated average life: average of the average lives along the interest-rate paths
- For each interest-rate path, there is an average life. The average of these average lives is the average life reported in an OAS model.
- Additional information is conveyed by the distribution of the average life. The greater the range and standard deviation of the average life, the more uncertainty there is about the tranche’s average life.