FAS 133 hedge accounting and flourishing mortgage origination have forced mortgage servicers to pay unprecedented attention to systematic valuation of mortgage servicing rights (MSR). "Traditionalists" of the MSR world continue to claim that these instruments are still commonly priced via simple static valuation. This idea is often proliferated because the benefits of an option adjusted valuation methodology that properly takes volatility into consideration are currently not fully recognized. However, does a purely static valuation actually exist?

Guess the yield!
The mortgage-refinancing curve has an S-like shape - it gradually saturates when the refinancing incentive becomes too large or too small. If an IO or a MSR is taken off a high-premium pool, its price exhibits positive convexity because the life of the collateral can extend (if rates rise) but can barely be further contracted (if rates fall). The value of this IO is, therefore, higher when measured in a volatile market than would normally be seen in a static world. To replicate this effect using the static valuation method, the yield should be artificially lowered - in order to compensate for overlooked positive convexity. Similarly, IOs and MSRs stripped off a deeply discounted pool will exhibit negative convexity and can be correctly valued using only a relatively high yield in a static valuation formula. The variability in the yield of IOs, as shown in the chart below, suggests that only someone possessing a magical talent in guessing the yield can value widely traded market IOs using the static valuation method.