Analysis of Residential Mortgage-Backed Securities: Chapter Summary

CHAPTER 19
ANALYSIS OF RESIDENTIAL
MORTGAGE-BACKED SECURITIES
CHAPTER SUMMARY
There are two approaches to the analysis of residential mortgage-backed securities including
pass-throughs, collateralized mortgage obligations (CMOs), and stripped mortgage-backed
securities. They are: (1) the static cash flow yield methodology, and (2) the Monte Carlo
simulation methodology. In this chapter we review the static cash flow yield methodology and its
limitations and then focus on the Monte Carlo simulation methodology. The framework provided
in this chapter applies to agency and nonagency residential mortgage-backed securities.
STATIC CASH FLOW YIELD METHODOLOGY
The static cash flow yield methodology begins with the computation of the cash flow yield
measure used for pass-throughs and based on some prepayment assumption.
Vector Analysis
One practice that market participants use to overcome the drawback of the PSA benchmark is to
assume that the PSA speed can change over time. This technique is referred to as vector
analysis. A vector is simply a set of numbers. In the case of prepayments, it is a vector of
prepayment speeds. Vector analysis is particularly useful for CMO tranches that are dramatically
affected by the initial slowing down of prepayments, and then speeding up of prepayments, or
vice versa.
Limitations of the Cash Flow Yield
The same shortcomings found in the yield to maturity approach are also present in application of
the cash flow yield measure: (i) the projected cash flows are assumed to be reinvested at the cash
flow yield, and (ii) the RMBS is assumed to be held until the final payout based on some
prepayment assumption. The cash flow yield is dependent on realization of the projected cash
flow according to some prepayment rate. If actual prepayments vary from the prepayment rate
assumed, the cash flow yield will not be realized.
Yield Spread to Treasuries
The yield for a RMBS will depend on the actual prepayment experience of the mortgages in the
pool. Nevertheless, the convention in all fixed-income markets is to measure the yield on
a non-Treasury security to that of a comparable Treasury security.
The repayment of principal over time makes it inappropriate to compare the yield of a RMBS to
a Treasury of a stated maturity. Instead, market participants have used two measures: Macaulay
duration and average life.
Copyright 2016 Pearson Education, Inc. 412

Static Spread
The static spread is the yield spread in a static scenario (i.e., no volatility of interest rates) of the
bond over the entire theoretical Treasury spot rate curve, not a single point on the Treasury yield
curve.
In a relatively flat interest-rate environment, the difference between the traditional yield spread
and the static spread will be small.
There are two ways to compute the static spread for RMBS. One way is to use todays yield
curve to discount future cash flows and keep the mortgage refinancing rate fixed at todays
mortgage rate. Use of this approach to calculate the static spread recognizes different prices
today of dollars to be delivered at future dates.
The second way to calculate the static spread allows the mortgage rate to go up the curve as
implied by the forward interest rates. This procedure is sometimes called the zero-volatility
OAS or simply the Z-spread. In this case a prepayment model is needed to determine the vector
of future prepayment rates implied by the vector of future refinancing rates.
Effective Duration
Modified duration is a measure of the sensitivity of a bonds price to interest-rate changes,

assuming that the expected cash flow does not change with interest rates. Modified duration is
consequently not an appropriate measure for mortgage-backed securities, because prepayments
influence the projected cash flow as interest rates change. When interest rates fall (rise),
prepayments are expected to rise (fall). As a result, when interest rates fall (rise), duration may
decrease (increase) rather than increase (decrease). This property is referred to as negative
convexity.
Negative convexity has the same impact on the price performance of a RMBS as it does on the
performance of a callable bond. When interest rates decline, a bond with an embedded call
option, which is what a RMBS is, will not perform as well as an option-free bond. Although
modified duration is an inappropriate measure of interest-rate sensitivity, there is a way to allow
for changing prepayment rates on cash flow as interest rates change. This is achieved by
calculating the effective duration, which allows for changing cash flow when interest rates
change.
To illustrate, consider tranche data: P_ = 102.1875; P+ = 98.4063; P0 (initial price) = 100.2813;

y = 0.0025. Substituting into the modified duration formula yields, we have:
P P 102.1875 98.4063
modified duration (with P_ = 102.1875) = = = 7.54.
2 P0 y 2(100.2813)(0.0025)
To further illustrate, consider tranche data: P_ = 101.9063 (at 200 PSA; basis points decrease);
P+ = 98.3438 (at 150 PSA; basis point increase); P0 = 100.2813; y = 0.0025. Substituting into
the effective duration formula yields

P P 101.9063 98.3438
effective duration (P_ = 101.9063) = = = 7.11.
2 P0 y 2(100.2813)(0.0025)
Notice that the effective duration (which allows for changing cash flow when interest rates
change) is less than the modified duration.
The divergence between modified duration and effective duration is much more dramatic for
bond classes trading at a substantial discount from par or at a substantial premium over par.
Effective Convexity
To illustrate the convexity formula, consider the above tranche data. The standard convexity is
approximated as follows:
P P 2 P0 98.4063 102.1875 2(100.2813)

= = 49.78.
P0 y
2
(100.2813)(0.0025) 2
The effective convexity (which allows for changing cash flow when interest rates change so that
P_ = 101.9063) is
P P 2 P0 98.3438 101.9063 2(100.2813)

= = 398.88.
P0 y
2
(100.2813)(0.0025) 2
The standard convexity indicates positive convexity, whereas the effective convexity indicates
they have negative convexity. The difference is even more dramatic for bonds not trading near
par.
For a PO created from a tranche, the standard convexity can be close to zero whereas the
effective convexity can be very large. For example, if the effective convexity is 2,000, and the
yields change by 100 basis points, the percentage change in price due to convexity is:
(effective convexity)(y)2 = 2,000(0.01)2 = 0.2000 or 20.00%.
Prepayment Sensitivity Measure
The value of a RMBS will depend on prepayments. To assess prepayment sensitivity, market
participants have used the following measure: the basis point change in the price of an RMBS for
a 1% increase in prepayments. Specifically, we have:
prepayment sensitivity = (Ps P0)100
where Ps = price (per $100 par value) assuming a 1% increase in prepayment speed and P0 =
initial price (per $100 par value) at assumed prepayment speed.

Notice that a security that is adversely affected by an increase in prepayment speeds will have
a negative prepayment sensitivity while a security that benefits from an increase in prepayment
speed will have a positive prepayment sensitivity.
MONTE CARLO SIMULATION METHODOLOGY
For some fixed-income securities and derivative instruments, the periodic cash flows are path
dependent. This means that the cash flows received in one period are determined not only by the
current and future interest-rate levels but also by the path that interest rates took to get to the
current level.
Pools of pass-throughs are used as collateral for the creation of collateralized mortgage
obligations (CMOs). Consequently, for CMOs there are typically two sources of path
dependency in a CMO tranches cash flows.
First, the collateral prepayments are path dependent. Second, the cash flow to be received in the
current month by a CMO tranche depends on the outstanding balances of the other tranches in
the deal. Thus we need the history of prepayments to calculate these balances.
Because of the path dependency of a RMBSs cash flow, the Monte Carlo simulation method is
used for these securities rather than the binomial method. Conceptually, the valuation of
pass-throughs using the Monte Carlo method is simple. In practice, however, it is very complex.
The simulation involves generating a set of cash flows based on simulated future mortgage
refinancing rates, which in turn imply simulated prepayment rates.
Valuation modeling for CMOs is similar to valuation modeling for pass-throughs, although the
difficulties are amplified because the issuer has sliced and diced both the prepayment risk and
the interest-rate risk into smaller pieces called tranches. The sensitivity of the pass-throughs
composing the collateral to these two risks is not transmitted equally to every tranche. Some of
the tranches wind up more sensitive to prepayment risk and interest-rate risk than the collateral,
whereas some of them are much less sensitive.
Using Simulation to Generate Interest-Rate Paths and Cash Flows
The typical model that Wall Street firms and commercial vendors use to generate random
interest-rate paths takes as inputs todays term structure of interest rates and a volatility
assumption. The term structure of interest rates is the theoretical spot rate (or zero-coupon) curve
implied by todays Treasury securities. The volatility assumption determines the dispersion of
future interest rates in the simulation. The simulations should be normalized so that the average
simulated price of a zero-coupon Treasury bond equals todays actual price.
The simulation works by generating many scenarios of future interest-rate paths. In each month
of the scenario, a monthly interest rate and a mortgage refinancing rate are generated. The
monthly interest rates are used to discount the projected cash flows in the scenario. The mortgage
refinancing rate is needed to determine the cash flow because it represents the opportunity cost

the mortgagor is facing at that time.
Prepayments are projected by feeding the refinancing rate and loan characteristics, such as age,
into a prepayment model. Given the projected prepayments (voluntary and involuntary), the cash
flow along an interest-rate path can be determined.
Calculating the Present Value for a Scenario Interest-Rate Path
Given the cash flow on an interest-rate path, its present value can be calculated. The discount
rate for determining the present value is the simulated spot rate for each month on the
interest-rate path plus an appropriate spread. The spot rate on a path can be determined from the
simulated future monthly rates. The relationship that holds between the simulated spot rate for
month T on path n and the simulated future one-month rates is
1+f (n)1 + f (n) . . . 1 + f (n)

1/T
zT(n) = 1 2 T 1
where zT(n) = simulated spot rate for month T on path n, and fj(n) = simulated future one-month
rate for month j on path n.
The present value of the cash flow for month T on interest-rate path n discounted at the simulated
spot rate for month T plus some spread is
CT (n)
PV[CT(n)] =
1 z T (n) K
T
where PV[CT(n)] = present value of cash flow for month T on path n, CT (n) = cash flow for
month T on path n, zT (n) = spot rate for month T on path n, and K = appropriate risk-adjusted
spread.
The present value for path n is the sum of the present value of the cash flow for each month on
path n.
Determining the Theoretical Value
The present value of a given interest-rate path can be thought of as the theoretical value of
a pass-through assuming that the path was actually realized. The theoretical value of the
pass-through can be determined by calculating the average of the theoretical value of all the
interest-rate paths.
Looking at the Distribution of the Path Values
The theoretical value generated by the Monte Carlo simulation method is the average of the path
values. There is valuable information in the distribution of the path values. If there is substantial
dispersion of the path values then the investor is warned about the potential variability of the
models value.

Simulated Average Life
The average life reported in a Monte Carlo analysis is the average of the average lives along the
interest-rate paths. The greater the range and standard deviation of the average life, the more
uncertainty there is about the securitys average life.
Option-Adjusted Spread
The option-adjusted spread is a measure of the yield spread that can be used to convert dollar
differences between value and price. It represents a spread over the issuers spot rate curve or
benchmark. In the Monte Carlo model, the OAS is the spread K that when added to all the spot
rates on all interest-rate paths will make the average present value of the paths equal to the
observed market price (plus accrued interest).
Option Cost
The implied cost of the option embedded in any RMBS can be obtained by calculating the
difference between the OAS at the assumed volatility of interest rates and the static spread:
option cost = static spread option-adjusted spread.
Effective Duration and Convexity
Effective duration and effective convexity can be calculated using the Monte Carlo method as
follows. First, the bonds OAS is found using the current term structure of interest rates. Next,
the bond is repriced holding OAS constant but shifting the term structure. Two shifts are used to
get the prices needed to apply the effective duration and effective convexity formulas: (i) yields
are increased, and (ii) yields are decreased.
Selecting the Number of Interest-Rate Paths
Lets now address the question of the number of scenario paths or repetitions, N, needed to value
a RMBS. A typical OAS run will be done for 512 to 1,024 interest-rate paths.
The number of interest-rate paths determines how good the estimate is, not relative to the truth
but relative to the model. The more paths, the more average spread tends to settle down. It is
a statistical sampling problem.
Most Monte Carlo simulation models employ some form of variance reduction to cut down on
the number of sample paths necessary to get a good statistical sample. Variance reduction
techniques allow us to obtain price estimates within a tick.
Drawbacks of the OAS Methodology
The OAS methodology provides a measure for relative valuation of MBS products that is vastly

superior to some of the ad hoc measures that were historically used (and unfortunately still used)
by portfolio managers. Those traditional measures fail to recognize the embedded options in
these complex products. Nevertheless, using the OAS as a relative value measure has drawbacks.
The first drawback is the prepayment model uncertainty. The second drawback is that in pricing
MBS, there are differing OAS levels.
OAS Constancy Problem
There is a problem with calculating price sensitivity measures such as interest-rate and
prepayment sensitivity using the OAS methodology. Recall that in measuring effective duration
and effective convexity, the calculation assumed that the OAS is held constant and the interest-
rate paths are shifted by a specified number of basis points. After adding the initial OAS to the
new interest-rate paths, a security is then revalued to obtain the two values to be used in the
effective duration and convexity formulas. The trouble in assuming a constant OAS in
calculating interest-rate sensitivity measures is that the assumption cannot be justified on
theoretical grounds.
Thus, we have a serious problem with the notion of keeping OAS constant for measuring price
sensitivity to changes to all sensitivity measures (e.g., interest-rate and prepayment sensitivity).
One conclusion that can be drawn from this is to adjust (and use) a prepayment model so that it
equates OAS levels.
TOTAL RETURN ANALYSIS
Neither the static cash flow methodology nor the Monte Carlo simulation methodology will tell
a money manager whether investment objectives can be satisfied. The performance evaluation of
an individual RMBS requires specification of an investment horizon, whose length for most
financial institutions is dictated by the nature of its liabilities.
The measure that should be used to assess the performance of a security or a portfolio over some
investment horizon is the total return.
Horizon Price for CMO Tranches
The most difficult part of estimating total return is projecting the price at the horizon date. In the
case of a CMO tranche the price depends on the characteristics of the tranche and the spread to
Treasuries at the termination date. The key determinants are the quality of the tranche, its
average life (or duration), and its convexity. Quality refers to the type of CMO tranche.
Option-Adjusted Spread Total Return
The total return and OAS frameworks can be combined to determine the projected price at the
horizon date. At the end of the investment horizon, it is necessary to specify how the OAS is
expected to change. The horizon price can be backed out of the Monte Carlo simulation model.
Assumptions about the OAS value at the investment horizon reflect the expectations of the

money manager. It is common to assume that the OAS at the horizon date will be the same as the
OAS at the time of purchase. A total return calculated using this assumption is sometimes
referred to as a constant-OAS total return.
KEY POINTS
There are two methodologies commonly used to analyze all RMBS (agency and nonagency):
cash flow yield methodology and Monte Carlo simulation methodology.
The cash flow yield is the interest rate that will make the present value of the projected cash
flow from an RMBS equal to its market price. The cash flow yield assumes that (1) all the
cash flows can be reinvested at a rate equal to the cash flow yield, (2) the RMBS is held to the
maturity date, and (3) the prepayment speed used to project the cash flow will be realized. In
addition, the cash flow yield methodology fails to recognize that future interest-rate changes
will affect the cash flow.
Modified duration is not a good measure of price volatility for RMBS because it assumes that
the cash flow does not change as yield changes. Effective duration does take into
consideration how yield changes will affect prepayments and therefore cash flow.
An RMBS is a security whose cash flow is path dependent. This means that cash flow
received in one period is determined not only by the current and future interest-rate levels, but
also by the path that interest rates took to get to the current level.
A methodology used to analyze path-dependent cash flow securities is the Monte Carlo
simulation. This methodology involves randomly generating many scenarios of future
interest-rate paths, where the interest-rate paths are generated based on some volatility
assumption for interest rates. The random paths of interest rates should be generated from an
arbitrage-free model of the future term structure of interest rates. The Monte Carlo simulation
methodology applied to RMBS involves randomly generating a set of cash flows based on
simulated future mortgage refinancing rates.
The theoretical value of a security on any interest-rate path is the present value of the cash
flow on that path, where the spot rates are those on the corresponding interest-rate path.
The theoretical value of a security is the average of the theoretical values over all the interest-
rate paths. Information about the distribution of the path values is useful in understanding the
variability around the theoretical value.
The average life reported is the average of the average lives from all the interest-rate paths
and information about the distribution of the average life is useful.
In the Monte Carlo simulation methodology, the option-adjusted spread is the spread that
when added to all the spot rates on all interest-rate paths will make the average present value
of the paths equal to the observed market price (plus accrued interest).
The effective duration and effective convexity are calculated using the Monte Carlo
simulation methodology by holding the OAS constant and shifting the term structure up and
down.
Using the OAS as a relative value measure has drawbacks.

One problem with assuming a constant OAS in calculating interest-rate sensitivity measures is
that the assumption cannot be justified on theoretical grounds.
Total return is the correct measure for assessing the potential performance of CMO tranches
over a specified investment horizon.
The static cash flow yield or Monte Carlo simulation methodology can be incorporated into a
total return framework to calculate the mortgage-backed securitys price at the horizon date.
Scenario analysis is one way to evaluate the risk associated with investing in an RMBS.

ANSWERS TO QUESTIONS FOR CHAPTER 19
(Questions are in bold print followed by answers.)
1. Suppose you are told that the cash flow yield of a pass-through security is 9% and that
you are seeking to invest in a security with a yield greater than 8.8%. Answer the below
questions.
(a) What additional information would you need to know before you might invest in this
pass-through security?
To determine your chances of actually getting an 8.8% return, you would want to know the types
of securities backing the pass-through, the safety of the cash flows, and the expected volatility of
the cash flows. More details are given below.
A mortgage pass-through security consists of a set of marketable shares in a portfolio of

mortgages for which investors receive monthly payments of both interest and principal.
Normally the package is secured by credit insurance so that investors are protected from
the credit risks of the individual mortgages in the portfolio. However, no protection is
provided against the cash flow and return volatility associated with unanticipated principal
prepayments, which typically occur when interest rates drop and homeowners refinance
their mortgages. A conventional pass-through is a mortgage pass-through security that is
not guaranteed by a government agency.
If applicable, you would want to know the prepayment rate for a particular tranche formed from
the pass-through security as well as any stipulated guarantees in terms of interest and principal
payments. One should note that the greater the discount assumed to be paid for a tranche, the
more a tranche will benefit from faster prepayments. The converse is true for a tranche for which
a premium is paid. The faster the prepayments, the lower the cash flow yields.
The above factors along with an expected reinvestment rate will give you an idea as to whether
or not the 9% return will be realized.
(b) What are the limitations of the cash flow yield for assessing the potential return from
investing in a RMBS?
The limitations for the cash flow yield in a RMBS are like the yield to maturity for a bond where it
is assumed that the coupon payments can be reinvested at a rate equal to the yield to maturity and
the bond is held to maturity. These shortcomings are equally present in application of the cash flow
yield measure: (i) the projected cash flows are assumed to be reinvested at the cash flow yield, and
(ii) the RMBS is assumed to be held until the final payout based on some prepayment assumption.
The importance of reinvestment risk, the risk that the cash flow will be reinvested at a rate less than
the cash flow yield, is particularly important for many RMBS because payments come as
frequently as every month. The cash flow yield, moreover, is dependent on realization of the
projected cash flow according to some prepayment rate. If actual prepayments vary from the
prepayment rate assumed, the cash flow yield will not be realized.

2. Using the cash flow yield methodology, a spread is calculated over a comparable Treasury
security. How is a comparable Treasury determined?
Comparable treasury issue refers to a Treasury security that is selected (by an independent
investment banker) to have an actual or interpolated maturity comparable to the remaining term
of the debt securities to be redeemed that would be utilized, at the time of selection and in
accordance with customary financial practice, in pricing new issues of corporate debt securities
of comparable maturity to the remaining term of such debt securities.
At the time of purchase it is not possible to determine an exact yield for an RMBS; the yield will
depend on the actual prepayment experience of the mortgages in the pool. Nevertheless, the
convention in all fixed-income markets is to measure the yield on a non-Treasury security to that of a
comparable Treasury security. One way of determining a comparable Treasury is by matching
maturity. However, the repayment of principal over time makes it inappropriate to compare the yield
of non-Treasury instruments (such as a RMBS) to a Treasury of a stated maturity. Instead, market
participants have used two measures: Macaulay duration and average life. The practice of spreading
the yield to the average life on the interpolated Treasury yield curve is improper for an amortizing
bond even in the absence of interest-rate volatility. What should be done is to calculate the static
spread. This is the yield spread in a static scenario (no volatility of interest rates) of the bond over
the entire theoretical Treasury spot rate curve (and not a single point on the Treasury yield curve).
Of interest, the Federal Financial Institutions Examination Council has developed the rate spread
calculator that gives the spread between the APR and the comparable treasury security utilizing
the "Treasury Securities of Comparable Maturity under Regulation C" table, action taken, lock-in
date, APR, term (loan maturity), and lien status. The rate spread is the spread between the APR
on a loan and the rate on Treasury securities with comparable maturity periods for loan
originations in which the APR exceeds the applicable rate by a percentage specified by the
Board. The reporting requirement applies to originations of: home purchase loans, dwelling-
secured home improvement loans, and refinancings.
3. What is vector analysis?
One practice that market participants use to overcome the drawback of the PSA benchmark is to
assume that the PSA speed can change over time. This technique to deal with this drawback is
referred to as vector analysis. A vector is simply a set of numbers. In the case of prepayments, it
is a vector of prepayment speeds. Vector analysis is particularly useful for CMO tranches that are
dramatically affected by the initial slowing down of prepayments, and then speeding up of
prepayments, or vice versa.
4. In the calculation of effective duration and effective convexity, why is a prepayment model
needed?
A prepayment model will tell us how prepayments cause the projected cash flows to change as
interest rates change. This is needed because to properly compute effective duration and effective
convexity we must account for cash flows changing with interest rates.

5. The following excerpt is taken from an article titled Fidelity Eyes $250 Million Move
into Premium PACs and I-Os that appeared in the January 27, 1992, issue of BondWeek,
pp. 1 and 21:
Three Fidelity investment mortgage funds are considering investing this quarter a
total of $250 million in premium planned amortization classes of collateralized mortgage
obligations and some interest-only strips, said Jim Wolfson, portfolio manager Wolfson
will look mainly at PACs backed by 9-10% Federal Home Loan Mortgage Corp. and
Federal National Mortgage Association pass-throughs. These have higher option-adjusted
spreads than regular agency pass-throughs, or similar premium Government National
Mortgage Association-backed, PACs, he said. He expects I-Os will start to perform better
as prepayments start to slow later in this quarter.
The higher yields on I-Os and premium PACs compensate for their higher prepayment
risk, said Wolfson. You get paid in yield to take on negative convexity, he said. He does
not feel prepayments will accelerate
Answer the below questions.
(a) Why would premium PACs and interest-only strips offer higher yields if the market
expects that prepayments will accelerate or are highly uncertain?
Prepayments will be expected to accelerate if interest rates are expected to decline or if there is
a greater possibility of decline due to general uncertainty as to which way rates will change.
For such a situation, investors would expect to deal with greater reinvestment rate risk. To
compensate for this risk, investors would have to be given higher rates of return for investing
in securities that will be retired earlier than desired. More details on how this affects both
planned amortization tranches (PAC tranches) and interest-only strips (I-Os or just IOs) are
given below.
PAC tranches can reduce prepayment risk in a manner desired by an investors preference.
However, despite the redistribution of prepayment risk with sequential-pay and accrual
collateralized mortgage obligations (CMOs), there is still considerable prepayment risk. That is,
there is still considerable average life variability for a given tranche. This problem is mitigated
by the PAC tranche. The greater predictability of the cash flow for PAC bonds occurs because
there is a principal repayment schedule that must be satisfied. PAC bondholders have priority
over all other classes in the CMO issue in receiving principal payments from the underlying
collateral. The greater certainty of the cash flow for the PAC bonds comes at the expense of the
non-PAC classes, called support or companion bonds. It is these bonds that absorb the
prepayment risk. Because PAC bonds have protection against both extension risk and contraction
risk, they are said to provide two-sided prepayment protection.
In early 1987, stripped MBS began to be issued where all the interest is allocated to one
class (the IO class) and the entire principal to the other class (the PO class). The IO class
receives no principal payments. IOs and POs are referred to as mortgage strips. The PO
security is purchased at a substantial discount from par value. The yield an investor will

realize depends on the speed at which prepayments are made. The faster the prepayments,
the higher the yield the investor will realize. When an IO is purchased there is no par value.
In contrast to the PO investor, the IO investor wants prepayments to be slow. The reason is
that the IO investor receives only interest on the amount of the principal outstandi ng. As
prepayments are made, the outstanding principal declines, and less dollar interest is
received. In fact, if prepayments are too fast, the IO investor may not recover the amount
paid for the IO.
(b) What does Wolfson mean when he says: You get paid in yield to take on negative
convexity?
Negative convexity has the same impact on the price performance of a RMBS as it does on the
performance of a callable bond. When interest rates decline, a bond with an embedded call
option, which is what a RMBS is, will not perform as well as an option-free bond. Thus,
Wolfson is pointing out that investors will require higher yields for such investments or
equivalently: You get paid in yield to take on negative convexity.
(c) What measure is Wolfson using to assess the risks associated with prepayments?
Because Wolfson is looking at securities that can experience a decline when prepayment
increases, Wolfson wants a measure that captures this. Thus, Wolfson appears to be cognizant of
the prepayment sensitivity measure. More details on this measure are supplied below.
The value of a RMBS will depend on prepayments. To assess prepayment sensitivity, market
participants have used the prepayment sensitivity measure that determines the basis point change in
the price of an RMBS for a 1% increase in prepayments. Specifically, this measure is defined as
prepayment sensitivity = (Ps P0)100 where Ps = price (per $100 par value) assuming a 1% increase
in prepayment speed, and P0 = initial price (per $100 par value) at assumed prepayment speed.
For example, suppose that for some RMBS at 300 PSA the price is P0 = 106.10. A 1% increase
in the PSA prepayment rate means that PSA increases from 300 PSA to 303 PSA. Suppose that
at 303 PSA the price is recomputed using a valuation model to be P0 = 106.01. Therefore,
prepayment sensitivity = (106.01 106.10)100 = 9. Notice that a security that is adversely
affected by an increase in prepayment speeds will have a negative prepayment sensitivity while a
security that benefits from an increase in prepayment speed will have
a positive prepayment sensitivity.
6. In an article titled CUNA Mutual Looks for Noncallable Corporates that appeared in
the November 4, 1991, issue of BondWeek, p. 6, Joe Goglia, a portfolio manager for CUNA
Mutual Insurance Group, stated that he invests in planned amortization class tranches,
which have less exposure to prepayment risk and are more positively convex than other
mortgage-backeds. Is this true?
As seen below there are a lot of factors to consider before we assume that a PAC tranche will
absolutely have less exposure to prepayment risk and will be more positively convex that other
mortgage-backed securities.

The creation of a mortgage-backed security cannot make prepayment risk disappear. This is true
for both a pass-through and a CMO. Thus the reduction in prepayment risk (both extension risk
and contraction risk) that a PAC offers must come from somewhere. It comes from the support
bonds. If the support bonds are paid off quickly because of faster-than-expected prepayments,
there is no longer any protection for the PAC bonds.
Planned amortization class tranches are structured to have less exposure to prepayment
risk. For a security that is option-free and displays positive convexity, the price
appreciation will be greater than the price depreciation for a large change in yield.
Negative convexity means that the price appreciation will be less than the price
depreciation for a large change in yield.
Generally, the market will take the greater convexity bonds into account in pricing them. How
much should the market want investors to pay up for convexity? If investors expect that market
yields will change by very littlethat is, they expect low interest rate volatilityinvestors
should not be willing to pay much for convexity. In fact, if the market prices convexity high,
investors with expectations of low interest rate volatility will probably want to sell
convexity.
In the case of a CMO tranche the price depends on the characteristics of the tranche and the
spread to Treasuries at the termination date. The key determinants are the quality of the
tranche, its average life (or duration), and its convexity. Quality refers to the type of CMO
tranche. Consider, for example, that an investor can purchase a CMO tranche that is a PAC bond
but as a result of projected prepayments could become a sequential-pay tranche.
As another example, suppose that a PAC bond is the longest-average-life tranche in a reverse
PAC structure. Projected prepayments in this case might occur in an amount to change the class
from a long-average-life PAC tranche to a support tranche. The converse is that the quality of a
tranche may improve as well as deteriorate. For example, the effective collar for a PAC tranche
could widen at the horizon date when prepayment circumstances increase the par amount of
support tranches outstanding as a proportion of the deal.
For a tranche, a standard convexity can indicate positive convexity, whereas the effective
convexity can indicates negative convexity. The difference is even more dramatic for securities
not trading near par. For a PO created from a tranche, the standard convexity can be close to zero
whereas the effective convexity can be very large.
7. What is a path-dependent cash flow security?
For some fixed-income securities and derivative instruments, the periodic cash flows are path
dependent. This means that the cash flows received in one period are determined not only by the
current and future interest-rate levels but also by the path that interest rates took to get to the
current level.
8. Why is a pass-through security a path-dependent cash flow security?

In the case of mortgage pass-through securities, prepayments are path dependent because this
months prepayment rate depends on whether there have been prior opportunities to
refinance since the underlying mortgages were originated.
Unlike mortgage loans, the decision as to whether a corporate issuer will elect to refund an
issue when the current rate is below the issues coupon rate is not dependent on how rates
evolved over time to the current level. Moreover, in the case of adjustable-rate pass-throughs
(ARMs), prepayments are not only path dependent but the periodic coupon rate depends on the
history of the reference rate upon which the coupon rate is determined. This is because ARMs
have periodic caps and floors as well as a lifetime cap and floor.
9. Give two reasons why a CMO tranche is a path-dependent cash flow security.
Pools of pass-throughs are used as collateral for the creation of collateralized mortgage
obligations (CMOs). Consequently, for CMOs there are typically two sources of path
dependency in a CMO tranches cash flows. First, the collateral prepayments are path dependent.
Second, the cash flow to be received in the current month by a CMO tranche depends on the
outstanding balances of the other tranches in the deal. Thus we need the history of prepayments
to calculate these balances.
10. Explain how, given the cash flow on the simulated interest-rate paths, the theoretical
value of a RMBS is determined.
Given the cash flow on an interest-rate path, its present value can be calculated. The discount
rate for determining the present value is the simulated spot rate for each month on the
interest-rate path plus an appropriate spread. The spot rate on a path can be determined from the
simulated future monthly rates. The relationship that holds between the simulated spot rate for
month T on path n and the simulated future one-month rates is
1+f (n)1 + f (n) . . . 1 + f (n)

1/T
zT(n) = 1 2 T 1
where zT(n) = simulated spot rate for month T on path n, and fj(n) = simulated future one-month
rate for month j on path n.
The interest-rate path for the simulated future one-month rates can be converted to the
interest-rate path for the simulated monthly spot rates. Thus, the present value of the cash flow
for month T on interest-rate path n discounted at the simulated spot rate for month T plus some
spread is:
CT (n)
PV[CT(n)] =
1 z T (n) K
T
where PV[CT(n)] = present value of cash flow for month T on path n, CT(n) = cash flow for
month T on path n, zT(n) = spot rate for month T on path n, and K = appropriate risk-adjusted

spread.
The present value for path n is the sum of the present value of the cash flow for each month on
path n. We have (assuming a maturity of 360 months that consists of a path of 360 simulated
interest-rate path scenarios):
PV[path(n)] = 1/ 360 PV C1 (n) PV C2 (n) + . . . +PV C360 (n)
where PV[path(n)] is the present value of interest-rate path n.
The present value of a given interest-rate path can be thought of as the theoretical value of
a pass-through if that path was actually realized. The theoretical value of the pass-through can
be determined by calculating the average of the theoretical value of all the interest-rate paths.
That is, the theoretical value is equal to
theoretical value = 1/ N PV path(1) PV path(2) + . . . + PV path(N ) .
This procedure for valuing a pass-through is also followed for a CMO tranche. The cash flow
for each month on each interest-rate path is found according to the principal repayment and
interest distribution rules of the deal.
11. Explain how, given the cash flow on the simulated interest-rate paths, the average life
of a RMBS is determined.
Given the cash flow on the simulated interest-rate paths, the average life can be determined for
each path. The average life reported in a Monte Carlo analysis is the average of the average
lives along the interest-rate paths. As with the theoretical value, 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 securitys average life.
12. Suppose that a support bond is being analyzed using the Monte Carlo simulation
methodology. The theoretical value using 1,500 interest-rate paths is 88. The range for
the path present values is a low of 50 and a high of 115. The standard deviation is 15
points. How much confidence would you place on the theoretical value of 88?
The probability of actually achieving a theoretical value of 88 is not very likely. However, we
can put a probability of occurrence for a range of values surrounding 88. For example, if we
can assume a distribution resembling a normal distribution, then we know there is about a two-
thirds probability that we will find a range of values between 73 and 103. Nevertheless, given
the range of low and high values it appears the distribution is not perfectly normal but skewed
to the left, thus taking on more values below 88 than above 88.
13. In a well-protected PAC structure, what would you expect the distribution of the path
present values and average lives to be compared to a support bond from the same CMO
structure?

PAC tranches are structured to meet the designs of the investor who prefers a reduction is
risk. The greater predictability of the cash flow for PAC bonds occurs because there is a
principal repayment schedule that must be satisfied. PAC bondholders have priority over all
other classes in the CMO issue in receiving principal payments from the underlying
collateral. The greater certainty of the cash flow for the PAC bonds comes at the expense of
the non-PAC classes, called support or companion bonds. It is these bonds that absorb the
prepayment risk.
Because PAC bonds have protection against both extension risk and contraction risk, they are
said to provide two-sided prepayment protection. In conclusion, with less risk and
uncertainty in a well-protected PAC structure, we would expect the distribution of the path
present values and average lives to be more stable compared to a support bond from the same
CMO structure.
14. Suppose that the following values for a RMBS are correct for each assumption:
PSA Assumption Value of Security

192 112.10
194 111.80
200 111.20
202 111.05
210 110.70
Assuming that the value of the security in the market is 111.20 based on 200 PSA. What is
the prepayment sensitivity of this security?
To assess prepayment sensitivity, market participants have used the following measure. This
measure determines the basis point change in the price of an RMBS for a 1% increase in
prepayments. We have:
prepayment sensitivity = (Ps P0)100
where Ps = price (per $100 par value) assuming a 1% increase in prepayment speed and P0 =
initial price (per $100 par value) at assumed prepayment speed.
In our problem, we find a 1% increase from a PSA assumption from 200 to 202, i.e., (202 200)
/ 200 = 2 / 200 = 0.01 or 1.00%. For these PSA assumptions, the initial price (per $100 par
value) is P0 = 111.20 and the price assuming a 1% increase in prepayment speed is Ps = 111.05.
Inserting in these values in our formula gives:
prepayment sensitivity = (Ps P0)100 = (111.05 111.20)100 = 15.
The security in our problem has a negative prepayment sensitivity. This indicates that it is
adversely affected by an increase in prepayment.

15. An analysis of a CMO structure using the Monte Carlo method indicated the following,
assuming 12% volatility:
OAS (basis points) Static Spread (basis points)

Collateral 80 120
Tranche
PAC I A 40 60
PAC I B 55 80
PAC I C 65 95
PAC II 95 125
Support 75 250
(a) Calculate the option cost for each tranche.
The implied cost of the option embedded in any RMBS can be obtained by calculating the
difference between the OAS at the assumed volatility of interest rates and the static spread. We
use the below formula:
option cost = static spread option-adjusted spread.
The reason that the option cost is measured in this way is as follows. In an environment of no
interest-rate changes, the investor would earn the static spread. When future interest rates are
uncertain, the spread is less, however, because of the homeowners option to prepay; the OAS
reflects the spread after adjusting for this option. Therefore, the option cost is the difference
between the spread that would be earned in a static interest-rate environment (the static spread)
and the spread after adjusting for the homeowners option.
Below we compute the option cost for each tranche.
Tranche PAC I A: option cost = 60 basis points 40 basis = 20 basis points.

Tranche PAC I B: option cost = 80 basis points 55 basis = 25 basis points.
Tranche PAC I C: option cost = 95 basis points 65 basis = 30 basis points.
Tranche PAC II: option cost = 125 basis points 95 basis = 30 basis points.
Support: option cost = 250 basis points 75 basis = 175 basis points.
In general, a tranches option cost is more stable than its OAS in the face of market movements.
This interesting feature is useful in reducing the computational costs of calculating the OAS as
the market moves. For small market moves, the OAS of a tranche may be approximated by
recalculating the static spread (which is relatively cheap and easy to calculate) and subtracting its
option cost.
(b) Which tranche is clearly too rich?
The support tranche is rich relative to Treasuries. We might add that a typical OAS run will be
done for 512 to 1,024 interest-rate scenario paths to value a RMBS. The scenarios generated
using the simulation method look very realistic and, furthermore, reproduce todays Treasury
curve. By employing this technique, the money manager is effectively saying that Treasuries are

fairly priced today and that the objective is to determine whether a specific RMBS is rich or
cheap relative to Treasuries. The number of interest-rate paths determines how good the
estimate is, not relative to the truth but relative to the model. The more paths, the more average
spread tends to settle down.
(c) What would happen to the static spread for each tranche if a 15% volatility is assumed?
At the higher level of assumed interest-rate volatility of 15%, the static spread would fall because
of the homeowners option to prepay. This would negatively affect the collateral with its loss
distributed among the tranches with tranches with longer duration experiencing greater losses.
Tranche Z and any residual tranche would be least affected.
(d) What would happen to the OAS for each tranche if a 15% volatility is assumed?
The OAS would fall for each tranche causing a negative change in price per dollar. As stated in
part (c), this would negatively affect the collateral with its loss distributed among the tranches
with tranches.
16. Why would the option-adjusted spread vary across dealer firms?
As discussed below, the option-adjusted spread will vary across dealer firms because each dealer
will make their own volatility assumptions.
In the Monte Carlo model, the OAS is the spread K that when added to all the spot rates on all
interest-rate paths will make the average present value of the paths equal to the observed market
price (plus accrued interest). The spread among dealer firms will differ to the extent interest-rate
paths and their volatility assumptions differ.
The typical model that Wall Street firms and commercial vendors use to generate random
interest-rate paths takes as input todays term structure of interest rates and a volatility
assumption. The term structure of interest rates is the theoretical spot rate (or zero-coupon) curve
implied by todays Treasury securities. The volatility assumption determines the dispersion of
future interest rates in the simulation. The simulations should be normalized so that the average
simulated price of a zero-coupon Treasury bond equals todays actual price.
Each model has its own model of the evolution of future interest rates and its own volatility
assumptions. Typically, there are no significant differences in the interest-rate models of dealer
firms and vendors, although their volatility assumptions can be significantly different.
17. Explain how the number of interest-rate paths used in the Monte Carlo simulation
methodology is determined.
The number of interest-rate paths used in the Monte Carlo simulation methodology is determined
by the number of sample paths necessary to get a good statistical sample to obtain a price
estimate within a tick. More details are given below.
What is the number of scenario paths or repetitions, N, needed to value a RMBS? A typical OAS

run will be done for 512 to 1,024 interest-rate paths. The scenarios generated using the
simulation method look very realistic and, furthermore, reproduce todays Treasury curve. By
employing this technique, the money manager is effectively saying that Treasuries are fairly
priced today and that the objective is to determine whether a specific RMBS is rich or cheap
relative to Treasuries.
The number of interest-rate paths determines how good the estimate is, not relative to the truth
but relative to the model. The more paths, the more average spread tends to settle down. It is
a statistical sampling problem.
Most Monte Carlo simulation models use some form of variance reduction to cut down on the
number of sample paths necessary to get a good statistical sample. Variance reduction
techniques allow us to obtain price estimates within a tick. By this we mean that if the model is
used to generate more scenarios, price estimates from the model will not change by more than
a tick. For example, if 1,024 paths are used to obtain the estimated price for a tranche, there is
little more information to be had from the model by generating more than that number of paths.
(For some very sensitive CMO tranches, more paths may be needed to estimate prices within
one tick.)
18. Explain why you agree or disagree with the following statement: When the Monte
Carlo simulation methodology is used to value a RMBS, a PSA assumption is employed for all
interest-rate paths.
As seen in the illustration and Exhibit 19-9, the collateral value of a CMO is not always
influenced by the PSA assumption when using the Monte Carlos simulation methodology.
However, the value of the tranches is influenced so that there is a need to employ an accurate
PSA assumption to gage how the price will change when prepayment assumptions change.
19. Answer the below questions.
(a) What assumption is made about the OAS in calculating the effective duration and
effective convexity of a RMBS?
There is a problem with calculating price sensitivity measures such as interest-rate and
prepayment sensitivity using the OAS methodology. Recall that in measuring effective duration
and effective convexity, the calculation assumed that the OAS is held constant and the interest-
rate paths are shifted by a specified number of basis points. After adding the initial OAS to the
new interest-rate paths, a security is then revalued to obtain the two values to be used in the
effective duration and convexity formulas. The trouble in assuming a constant OAS in
calculating interest-rate sensitivity measures is that the assumption cannot be justified on
theoretical grounds.
Thus, we have a serious problem with the notion of keeping OAS constant for measuring price
sensitivity to changes to all sensitivity measures (e.g., interest-rate and prepayment sensitivity).
One conclusion that can be drawn from this is to adjust (and use) a prepayment model so that it
equates OAS levels.

(b) Is it warranted?
As just noted, the trouble in assuming a constant OAS in calculating interest-rate sensitivity
measures is that the assumption cannot be justified or warranted on theoretical grounds. The
OAS methodology provides a measure for relative valuation of MBS products that is vastly
superior to some of the ad hoc measures that were historically used (and unfortunately still used)
by portfolio managers. Those traditional measures fail to recognize the embedded options in
these complex products. Nevertheless, using the OAS as a relative value measure has drawbacks.
The first drawback is the prepayment model uncertainty. The second drawback is that in pricing
MBS, there are differing OAS levels.
20. What are the limitations of the option-adjusted spread measure?
Although the OAS measure is much more useful than the static cash flow yield measure, it still
suffers from major pitfalls. These limitations apply not only to the OAS for RMBS but also the
OAS produced from a binomial model. First, the OAS is a product of the valuation model. The
valuation model may be poorly constructed because it fails to capture the true factors that affect
the value of particular securities. Second, in Monte Carlo simulation the interest-rate paths must
be adjusted so that on-the-run Treasuries are valued properly. That is, the value of an on-the-run
Treasury is equal to its market price or, equivalently, its OAS is zero. The process of adjusting
the interest-rate paths to achieve that result is ad hoc.
A third problem with the OAS is that it assumes a constant OAS for each interest rate path and
over time for a given interest-rate path. If there is a term structure to the OAS, this is not
captured by having a single OAS number. Finally, the OAS is dependent on the volatility
assumption, the prepayment assumption in the case of RMBS, and the rules for refunding in the
case of corporate bonds.
In addition, there is a problem with calculating an OAS for a portfolio by taking a weighted
average of the OAS of the individual portfolio holdings. Instead, if an OAS for a portfolio is
sought, it is necessary to obtain the portfolios cash flow along each interest-rate path. The OAS
is then the spread that will make the average portfolio value equal to the portfolios market
value.
21. What assumptions are required to assess the potential total return of a RMBS?
The measure that should be used to assess the performance of a security or a portfolio over some
investment horizon is the total return. The total dollars received from investing in a RMBS
consist of (i) the projected cash flow from the projected interest payments and the projected
principal repayment (scheduled plus prepayments), (ii) the interest earned on reinvestment of the
projected interest payments and the projected principal prepayments, and (iii) the projected price
of the RMBS at the end of the investment horizon.
To obtain the cash flow, a prepayment rate over the investment horizon must be assumed. The
second step requires assumption of a reinvestment rate. Finally, cash flow yield or Monte

Carlo simulation methodologies can be used to calculate the price at the end of the investment
horizon under a particular set of assumptions. Either approach requires assumption of the
prepayment rate and the Treasury rates (i.e., the yield curve) at the end of the investment
horizon. The cash flow yield methodology uses an assumed spread to a comparable Treasury to
determine the required cash flow yield, which is then used to compute the projected price. The
Monte Carlo simulation methodology requires an assumed OAS at the investment horizon.
From this assumption, the OAS methodology can produce the horizon price.
22. What are the complications of assessing the potential total return of a CMO tranched
using the total return framework?
The most difficult part of estimating total return is projecting the price at the horizon date. In the
case of a CMO tranche the price depends on the characteristics of the tranche and the spread to
Treasuries at the termination date. The key determinants are the quality of the tranche, its
average life (or duration), and its convexity.
Quality refers to the type of CMO tranche. Consider, for example, that an investor can purchase
a CMO tranche that is a PAC bond but as a result of projected prepayments could become
a sequential-pay tranche. As another example, suppose that a PAC bond is the
longest-average-life tranche in a reverse PAC structure. Projected prepayments in this case might
occur in an amount to change the class from a long-average-life PAC tranche to a support
tranche. The converse is that the quality of a tranche may improve as well as deteriorate. For
example, the effective collar for a PAC tranche could widen at the horizon date when
prepayment circumstances increase the par amount of support tranches outstanding as a
proportion of the deal.
To test the sensitivity of total return to various alternative assumptions scenario analysis is
helpful. Its limitation is that only a small number of potential scenarios can be considered, and it
fails to take into consideration the dynamics of changes in the yield curve and the dynamics of
the deal structure.
23. On July 1, 2013, the FHLMC 30-Year Generic 4% 2012 was analyzed using the Monte
Carlo valuation model of FactSet. At the time of the analysis the securitys price was
104.644 with accrued interest of 0.300 (per $100 par value). Summary information about
the security is as follows:
Coupon (%) 4.000

Maturity Date 01-Oct-2041
Issue Date 01-May-2012
Original Balance (USD) 26,885,718,052.11
Current Balance (USD) 23,341,475,489.50
Factor Date 01-Jun-2013
The results of a simulation using 200 interest-rate path are reproduced as follows:

YTM (%) 2.981
Average Life 5.307
Modified Duration 4.551
Effective Duration 4.135
Effective Convexity 1.905
Partial Duration6 Month 0.088
Partial Duration1 Year 0.097
Spread Duration 4.338
Spread (TRSY) 1.585
Z-Spread 97.232
OAS (TRSY) 95.158
OAS (Libor) 77.909
Projected CPR (PB WAVG) 14.870
Projected PSA (PB WAVG) 278.342
(a) Explain the meaning of each of the measures above.
YTM(%) is the percentage rate of return paid on a bond, note, or other fixed income security if
the investor buys and holds it to its maturity date. The calculation for YTM is based on the
coupon rate, length of time to maturity, and market price. It assumes that coupon interest paid
over the life of the bond will be reinvested at the same rate. Yield to maturity is the most popular
measure of yield in the market. It is the rate that will make the present value of a bond's cash
flows equal to its market price plus accrued interest. To find YTM, one has to develop the cash
flows and then, through trial and error, find the interest rate that makes the present value of cash
flow equal to the market price plus accrued interest.
Average Life is the length of time the principal of a debt issue is expected to be outstanding.
Average life is an average period before a debt is repaid through amortization or sinking fund
payments. To calculate the average life, multiply the date of each payment (expressed as a
fraction of years or months) by the percentage of total principal that has been paid by that date,
summing the results and dividing by the total issue size. Average Life is also called "weighted
average maturity" and "weighted average life."
Modified Duration is the ratio of Macaulay duration to 1 + y as the modified duration. The
equation is Macaulay duration divided by one plus the yield to maturity. The Macaulay duration
1C 2C nC nM
+ +. . .+ +
1 y 1 y 1 y 1 y
1 2 n n
is where P = price of the bond, C = semiannual

P
coupon interest, y = one-half the yield to maturity or required yield, n = number of semiannual
periods (number of years times 2), and M = maturity value.

Effective Duration is the approximate percentage change in price for a 100 basis point change
in rates. It allows for changing cash flow when interest rates change. Using the following
definitions of P_ = the bond's price if its yield falls by x basis points, P+ = the bond's price if its
yield rises by x basis points, P0 = the bond's initial price per $100 of par value, and y = change
in yield in decimal, we can use the following formula:
P P
effective duration = .
2 P0 y
Effective Convexity is the convexity of a bond calculated using cash flows that change with
yields and it allows for changing cash flow when interest rates change. In equation form we
have:
P P 2 P0
effective duration =
P0 y
2
where the definition for the variables were just given.
Partial Duration6 Month is the same as a key rate duration that estimate the sensitivity of a
security or a portfolio to changes in the yield curve and measure the sensitivities to movements
in the Treasury spot curve about the selected points for key maturities in this case 6 months.
The basic principle of key rate duration is to change the yield for a particular maturity of the
yield curve and determine the sensitivity of a security or portfolio to that change holding all other
yields constant. One application of partial duration is the calculation of option-adjusted duration
by changing a variable such the OAS while holding all other variables constant.
Partial Duration1 Year is same as above but the key maturity used is one year.
Partial Duration2 Year is same as above but the key maturity used is two years.
Partial Duration5 Year is same as above but the key maturity used is five years.
Partial Duration10 Year is same as above but the key maturity used is ten years.
Partial Duration30 Year is same as above but the key maturity used is thirty years.
Spread Duration measures the interest-rate sensitivity to changes in the OAS. It can be defined
as the sensitivity of the price of a bond to a 100 basis point change to its option-adjusted spread.
As the rate of the Treasury security in the option-adjusted spread increases, the rate of the
option-adjusted spread also increases.
Spread (TRSY) is the spread for the broad U.S. Treasury Index Fund.
Z-Spread is zero-volatility OAS or simply the constant spread that will cause the price of a
security to equal the present value of its cash flows when added to the yield at each point on the
spot rate Treasury curve where a cash flow is received. In essence, each cash flow is discounted

at a suitable Treasury spot rate plus the Z-spread. The Z-spread is also referred to as a "static
spread" or zero-volatility OAS.
OAS (TRSY) is the Option-Adjusted Spread for the broad U.S. Treasury Index Fund. In general,
OAS is a measurement of the spread of a fixed-income security rate and the risk-free rate of
return, which is adjusted to take into account an embedded option. Typically, an analyst would
use the Treasury securities yield for the risk-free rate. The spread is added to the fixed-income
security price to make the risk-free bond price the same as the bond.
OAS (Libor) is the Option-Adjusted Spread for LIBOR, which is the worlds most widely-used
benchmark for short-term interest rates. LIBOR represents the rates that some of the worlds
leading banks charge each other for short-term loans. LIBOR refers to the London Interbank
Offered Rate and serves as the first step to calculating interest rates on various loans throughout
the world. There are a total of 35 different LIBOR rates each business day. The most commonly
quoted rate is the three-month U.S. dollar rate.
Projected CPR (PB WAVG) is the estimated conditional prepayment rate that is equal to the
proportion of the principal of a pool of loans that is assumed to be paid off prematurely in each
period. The calculation of this estimate is based on a number of factors such as historical
prepayment rates for previous loans that are similar to ones in the pool and on future economic
outlooks. The constant CPR is the weighted arithmetic average of those monthly CPRs, where
the weights are the remaining principal balance.
Projected PSA (PB WAVG) is the estimated Public Securities Association rate from which the
schedule of principal repayment is protected. An assumed PSA speed allows the cash flow to be
projected.
(b) Given the computed convexity measure, how is this pass-through security expected to
perform compared to a comparable Treasury security if the term structure of Treasury
rates decreases substantially in a parallel fashion?
The static spread is the yield spread in a static scenario (i.e., no volatility of interest rates) of the
bond over the entire theoretical Treasury spot rate curve, not a single point on the Treasury yield
curve. The yield to maturity (using the FactSet term) is 2.981%. The yield to maturity is the
static cash flow yield which is of questionable value given the assumptions regarding the
realization of the cash flows and the ability to reinvest interim cash flows (principal payments
and interest).
The average life is 5.037, which is the average life based on the static cash flows. The Spread
(TRSY) is 1.585 and the Z-Spread is 97.232. FactSet uses a term structure of the short-term rate
volatility as the volatility assumption. It is derived from the interest-rate cap market.
Two benchmark rates were used in the Monte Carlo simulation analysis to determine the OAS:
Treasury rates and LIBOR. The OAS (TRSY) is 95.158 and the OAS (Libor) is 77.909. The
following price sensitivity measures were reported by FactSet:

Modified Duration 4.551
Effective Duration 4.135
Effective Convexity 1.905
Partial Duration6 Month 0.088
Spread Duration 4.338
For this security, the effective duration and modified duration are very similar at 4.551 and
4.135. The effective convexity is 1.905. Thus, the security is expected to have negative
convexity. Negative convexity means that the price appreciation will be less than the price
depreciation for a large change in yield of a given number of basis points. The partial durations
are the same as the key rate durations and measure the sensitivities to movements in the Treasury
spot curve about the selected points. The partial duration is negative for six months and peaks at
1.806 for ten years. The spread duration of 4.338 measures the interest-rate sensitivity to changes
in the OAS.

Analysis of Residential Mortgage-Backed Securities: Chapter Summary

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Analysis of Residential Mortgage-Backed Securities: Chapter Summary

Uploaded by

Copyright:

Available Formats

CHAPTER 19

STATIC CASH FLOW YIELD METHODOLOGY

Limitations of the Cash Flow Yield

Yield Spread to Treasuries

Copyright 2016 Pearson Education, Inc. 412

Modified duration is a measure of the sensitivity of a bonds price to interest-rate changes,

To illustrate, consider tranche data: P_ = 102.1875; P+ = 98.4063; P0 (initial price) = 100.2813;

Copyright 2016 Pearson Education, Inc. 413

P P 2 P0 98.4063 102.1875 2(100.2813)

P P 2 P0 98.3438 101.9063 2(100.2813)

(effective convexity)(y)2 = 2,000(0.01)2 = 0.2000 or 20.00%.

Prepayment Sensitivity Measure

prepayment sensitivity = (Ps P0)100

Copyright 2016 Pearson Education, Inc. 414

MONTE CARLO SIMULATION METHODOLOGY

Using Simulation to Generate Interest-Rate Paths and Cash Flows

Copyright 2016 Pearson Education, Inc. 415

Calculating the Present Value for a Scenario Interest-Rate Path

1+f (n)1 + f (n) . . . 1 + f (n)

Determining the Theoretical Value

Looking at the Distribution of the Path Values

Copyright 2016 Pearson Education, Inc. 416

option cost = static spread option-adjusted spread.

Effective Duration and Convexity

Selecting the Number of Interest-Rate Paths

Drawbacks of the OAS Methodology

Copyright 2016 Pearson Education, Inc. 417

OAS Constancy Problem

TOTAL RETURN ANALYSIS

Horizon Price for CMO Tranches

Option-Adjusted Spread Total Return

Copyright 2016 Pearson Education, Inc. 418

Copyright 2016 Pearson Education, Inc. 419

Copyright 2016 Pearson Education, Inc. 420

A mortgage pass-through security consists of a set of marketable shares in a portfolio of

Copyright 2016 Pearson Education, Inc. 421

3. What is vector analysis?

Copyright 2016 Pearson Education, Inc. 422

Answer the below questions.

Copyright 2016 Pearson Education, Inc. 423

Copyright 2016 Pearson Education, Inc. 424

7. What is a path-dependent cash flow security?

8. Why is a pass-through security a path-dependent cash flow security?

Copyright 2016 Pearson Education, Inc. 425

1+f (n)1 + f (n) . . . 1 + f (n)

Copyright 2016 Pearson Education, Inc. 426

PV[path(n)] = 1/ 360 PV C1 (n) PV C2 (n) + . . . +PV C360 (n)

where PV[path(n)] is the present value of interest-rate path n.

theoretical value = 1/ N PV path(1) PV path(2) + . . . + PV path(N ) .

Copyright 2016 Pearson Education, Inc. 427

PSA Assumption Value of Security

prepayment sensitivity = (Ps P0)100

prepayment sensitivity = (Ps P0)100 = (111.05 111.20)100 = 15.

Copyright 2016 Pearson Education, Inc. 428

OAS (basis points) Static Spread (basis points)

(a) Calculate the option cost for each tranche.

option cost = static spread option-adjusted spread.

Tranche PAC I A: option cost = 60 basis points 40 basis = 20 basis points.

(b) Which tranche is clearly too rich?

Copyright 2016 Pearson Education, Inc. 429

Copyright 2016 Pearson Education, Inc. 430

19. Answer the below questions.

Copyright 2016 Pearson Education, Inc. 431