Option adjusted spread

An option adjusted spread starts from the Z-spread framework and takes the option out. The bond's cash flows are run across many simulated interest rate paths under an assumed volatility, the issuer is allowed to call whenever calling is rational on that path, and the calculation solves for the constant spread that reproduces the market price across all of them.

Learn the direction of the adjustment. On a callable bond, where the option belongs to the issuer, the option adjusted spread sits below the Z-spread. On a putable bond, where the option belongs to the investor, it sits above. On a bond with no options the two are the same number.

This is what reconciles a bond that looks cheap on nominal spread and rich on an option adjusted basis: the headline yield is high partly because the investor has sold a call, and once that premium is removed the pure credit spread is unattractive. For relative value across different call structures, it is the only measure that compares like with like.

Be honest about its limits, because this is where practitioners are more careful than textbooks. It is model output rather than an observation, and it depends heavily on the volatility assumed. A volatility set too low undervalues the option and overstates the credit spread that remains, so two desks can publish different figures for the same bond and neither is wrong.