Answer: forward rates.

## Explanation **Option-Adjusted Spread (OAS)** is defined as the constant spread that must be added to the **1-year forward rates** in the binomial interest rate tree to make the theoretical value of a security equal to its market price. **Key points:** - In a zero volatility environment, the binomial tree collapses to a single path - The OAS is added to the **forward rates** along this path - This adjustment reconciles the bond's market price with its arbitrage-free value **Why forward rates?** - Forward rates represent the expected future short-term interest rates - Adding a constant spread to forward rates accounts for credit risk and other risk premia - This approach ensures consistency across the entire yield curve **Not spot rates or par rates because:** - Spot rates are for zero-coupon bonds of different maturities - Par rates are for bonds trading at par - Forward rates provide the most direct way to value bonds with embedded options in a binomial framework In practice, OAS is calculated by iteratively adjusting the spread added to forward rates until the model price equals the market price.

Author: LeetQuiz Editorial Team