Handbook of Finance: Valuation, Financial Modeling, and Quantitative Tools

Chapter 39. Valuing Mortgage-Backed and Asset-Backed Securities

FRANK J. FABOZZI, PhD, CFA, CPA

Professor in the Practice of Finance, Yale School of Management

Abstract: The valuing (or pricing) of a bond without an embedded option (that is, an option-free bond) is straightforward. The value is equal to the present value of the expected cash flows. Ignoring defaults, for an option-free bond the cash flows are known and consist of the periodic interest payments and principal at the maturity date. The interest or discount rates for computing the present value of the cash flows begin with the spot rates for a benchmark security and to those rates an appropriate spread is added. Moving from valuing option-free bonds to corporate bonds and agency debentures with embedded options is not simple. The interest rate–sensitive options that can be embedded into these bonds are call options, put options, accelerated sinking provisions, and, for floating-rate securities, caps on the interest rate. The reason valuation is complicated is that the embedded options must be taken into account and the theoretical option-free value of the bond must be adjusted accordingly. The technique typically used for valuing corporate bonds and agency debentures with embedded options is the lattice method. Mortgage-backed securities also have embedded options: The right of the borrowers in a loan pool to prepay their mortgage loan. However, because future cash flows for a loan pool are sensitive to not only the current ...