Valuation Commentary

Treating MBS settlement rigorously: AD&Co's OAS version 5.2
by Alex Levin

Recently we have been discussing ValueNet, our new backward induction system for MBS pricing. At the same time, AD&Co remains committed to further elevate the rigor of our "traditional" OAS application. Results of this work is version 5.2 that is still in a Beta-stage, but nevertheless has already become a better option than 5.1x.

Among several enhancements, the new version now supports settlement conditions with both "trading on balance" (TBA) and "trading on factor" (non-TBA). For the latter case, the system recognizes differences in delivery balances for various rate paths and includes "balance delivery" option into valuation. A rare system does this.

Balance delivery option

Balance delivery option results in an additional negative convexity for the dollar value of a non-TBA security arising due to the negative correlation between the percentage price and the balance being delivered.

Consider first a TBA delivery with a guaranteed balance. Suppose the risk-neutral world at delivery date contains 3 possible states, "up", "flat", and "down". The "up" state features high rates and low prices, let price of an MBS be 96. To reach the "down" state the rate must fall, so the price of the same MBS will become 101. For the "flat" world, the price is par. Let us further assume that all 3 states are equally likely.

Hence, the fair quoted price should be close to (1/3)*(96+100+101) = 99.

Consider now a specific security (not a TBA) typically traded "on factor". It means that the negotiated price at the trade date will apply to an unknown fraction of the balance remained after amortization between trade and settlement. Since there exists correlation between rates and prepayments we must assume that the remaining balance is likely to be higher in the "up" state than in the "down" state. Suppose that the original, trade-date, balance is $10M, which would drop to $9M at the up state, to $8M at the flat state, and to $7M at the down state. How would we value this forward transaction with an uncertain balance? >>>