In this chapter and the next, we describe various models and methodologies for valuing and comparing mortgage-backed securities (MBS). This chapter discusses various measures used to measure potential returns. Chapter 11 is dedicated to explaining the various methods for estimating the interest rate risk of MBS. Because many approaches to measuring the interest rate risk of MBS require as an input the value of a security at different interest rate levels, we begin with the topic of valuation before introducing these 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 called the *zero-volatility 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 byproduct of this model is a spread measure called the *option-adjusted spread*. This measure is superior to the nominal spread and the zero-volatility spread because it takes into account how cash flows may change when interest rates change. Put differently, it explicitly values changes in cash flow patterns that result from the homeowners’ ...

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