Mortgage-backed securities (MBS) are complex instruments with just as complex valuation models. A valuation model develops a pricing mechanism for a mortgage backed security using multiple classes of assumptions across a range of scenarios. These assumptions are themselves generated by sub-models and include:
On the interest rate modeling side there are two primary families of models.
Equilibrium models and Arbitrage free models.
An equilibrium model is based on a simplified macro model of interest rate drivers. For instance the Cox Ingersoll Ross (CIR) model assumes a mean reverting process (if rates go up, they must come down, if they come down they must go up) that makes assumptions about a long term average rate and an adjustment process that pulls interest rates back to the long term mean.
An arbitrage free model is a model that calibrates the output of the model on day one to the existing interest rate environment so that there are no opportunities for mis-pricing or arbitrage on day one between the real world and the interest rate model. For example the Black Derman and Toy (BDT) model calibrates the existing interest rate environment as represented by zero curves and the volatility at each point in the term structure with the model to project the entire forward rate term structure.
A default model needs and projects multiple factors dealing with the economy in general as well as the underlying portfolio of loans in specific. The economic model forecasts interest rates, the impact of a change in rates on housing prices and purchase and sale activity in the housing market as well as unsold inventory at the broader level. At the loan level it looks at the loan to value ratio and the value of the option for the home owner to default.
A prepayment model projects the amount and likelihood of prepayment and its impact on the life of the mortgage as well as the overall timing of cash flows for the portfolio of loans
When a borrower exercises the pre-payment option, the borrower pays down either a portion of the outstanding principal or the entire outstanding principal. Prepayments can occur for a number of reasons:
Buyer sells home: If a home owner chooses to relocate to another home, the mortgage property will get sold and trigger a prepayment.
Buyer refinances: When interest rates fall, a home owner can benefit by refinancing at lower rates to reduce his monthly mortgage payment.
Buyer defaults: The property is foreclosed and sold.
Prepayment model uses multiple factors to simulate the prepayment behavior of home owners. These factors may include:
Figure 1 Valuation of Mortgage Backed Securities
What is the best way of evaluating portfolio performance allocation strategies? Should we just compare risk, return or risk adjusted…
6 mins read Introducing Project Plain speak. Currently a work in progress Plain speak focuses on bringing intelligent financial reporting…
9 mins read What can we learn about oil markets from the last ten years? The next decade. The final…
5 mins read What does the data say about future direction of crude oil markets. We look at OPEC spare…