Asset-Liability and Liquidity Management

CHAPTER 7Valuation of Mortgage-Backed and Asset-Backed Securities

Securitization refers to the process of packaging financial instruments and creating new securities backed by the cash flows of the original instruments. The repackaging process distributes the risk of the original products where synthetic instruments created through the securitization process have various levels of risk and return. This provides investors with the option to select those structured securities that better fit their investment needs.

Mortgage loans constitute one of the largest sectors in financial markets all around the world, where many bank and non-bank institutions actively market, underwrite, and service them. To free up funding, mortgage issuers often package mortgages and sell them as new financial securities, backed by the cash flows of the pooled loans. These structured instruments, often referred to as mortgage-backed securities (MBSs), have a very liquid market and institutional investors actively trade and include them in their investment portfolios. Other financial instruments, such as student loans or car loans, are also used in the securitization. Many financial and non-financial companies package different asset types and sell structured notes, generally referred to as asset-backed securities (ABSs).

The complex structure of such synthetic instruments necessitates the use of more advanced valuation techniques than the simple discounted cash flow method. Uncertainty in contractual ...