Techniques for Valuing MBS

The fourth and final part of this book is devoted to describing the various methodologies, models, and techniques used to measure and quantify the returns and risks of MBS. This chapter discusses various measures used to gauge potential returns, while Chapter 11 is dedicated to explaining the methods for estimating the interest rate risk of MBS. Chapters 12 and 13 conclude with discussions of the actual processes for evaluating agency and private-label MBS. Because many approaches to measuring the interest rate risk of MBS require the values of a security at different interest rate levels, we begin with the topic of valuation before introducing risk measures. Valuation is also critical in applying other analytical tools such as total return analysis because the value of an MBS at the end of some investment horizon must be estimated.

We begin the current chapter by reviewing static cash flow yield analysis and the limitations of the nominal spread that results from this simple form of analysis. We then look at a better spread measure, Z-spread, but point out its limitation as a measure of relative value. The most commonly used and robust methodology used for valuing MBS, Monte Carlo simulation, is then described. A by-product of this model is option-adjusted spread. This measure is superior to the nominal spread and the Z-spread because it takes into account how cash flows may change when interest rates change. Put differently, it explicitly ...

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