Spread duration

As summarized above, spread duration describes the sensitivity of a bond’s price to a change in its option-adjusted spread (OAS). For those who may be unfamiliar with
the concept of option-adjusted spreads, we give a brief definition here. In a nutshell,
OAS is the constant spread (in basis points) which, when layered onto the Treasury
spot curve, equates the present value of a fixed-income security’s expected future
cash flows adjusted to reflect the exercise of any embedded options (calls, prepayments,
interest rate caps and so on) to its market price.

To solve for a security’s OAS, we invoke the appropriate option model (e.g. a
binomial or trinomial tree or finite difference algorithm for callable/puttable corporate
bonds, or some type of Monte Carlo-simulation for mortgage-backed and other
path-dependent securities) to generate expected future cash flows under interest rate
uncertainty and iteratively search for the constant spread which, when layered onto
the Treasury spot rates, causes the present value of those option-adjusted cash
flows, discounted at the Treasury spot rates plus the OAS, to equal the market price
of the security.