Valuing Mortgage-Backed and Asset-Backed Securities
In this appendix, we will explain the methodology for valuing asset-backed securities (ABS) and mortgage-backed securities (MBS) and measures of relative value. We begin by reviewing cash flow yield analysis and the limitations of the spread measure that is a result of that analysis—the nominal spread. We then look at a better spread measure called the zero-volatility spread, but point out its limitation as a measure of relative value for MBS products because of the borrower’s prepayment option and for ABS products where the prepayment option has value. Finally, we look at the methodology for valuing MBS and for ABS products where the prepayment option has value—the Monte Carlo simulation model. A byproduct of this model is a spread measure called the option-adjusted spread (OAS). This measure is superior to the nominal spread and the zero-volatility spread for ABS products where the prepayment option has a value because it takes into account how cash flows may change when interest rates change. That is, it recognizes the borrower’s prepayment option and how that affects prepayments when interest rates may change in the future. While the OAS is superior to the two other spread measures, it is based on assumptions that must be understood by an investor and the sensitivity of the security’s value and OAS to changes in those assumptions must be investigated.
CASH FLOW YIELD ANALYSIS
The yield on any financial instrument ...