Valuation Commentary - January '06

The Role of Fair Value, Model-Free Value and Risk-Neutrality
by Alex Levin

This month I decided to touch on these vital valuation concepts which, in essence, dominate many of my own consulting and development projects. Although most mortgage- and asset-backs are valued using models, I found out that many practitioners are not well-versed in some model limitations. As I will exhibit in this article, some MBS can be valued (exactly or approximately) without models. This alternative view allows for a basic validation of the outcome provided by complex computer models. In fact, successful investment steps exploring detected arbitrage opportunities and the hedging strategy can be undertaken without heavy reliance on models. I will give some examples, but will start with an explanation of the basic notions.

Main Concepts

Fair Value of a financial instrument is a value derived using a plausible valuation model reflecting (as perceived by financial engineers) relevant market laws. Fair value is therefore model-driven; the value is not more fair than the models employed for its derivation. Despite this problem, the fair value analysis is a useful method for many firms. It quantifies and “monetizes” the value of a position as a single number. For example, a mortgage company needs to know fair value, not to sell its mortgage servicing rights (MSR) business, but to assess the fundamental economics of the servicing business and hedge its exposures.

Model-Free Value is a price of a financial instrument that can be derived directly via prices of traded assets without a model. A classic example is the put-call parity for European options: cash plus call is equal to stock plus put regardless of the model for a stock’s behavior. Model-free valuation is possible when the asset’s cashflow can be replicated synthetically using other traded instruments. For example, in the mortgage industry, values of MSR can be approximated by values of traded IOs and POs (see further).

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