Valuation Commentary

Prepayment-Risk-and-Option-Adjusted-Spread Valuation: Conclusion

by Alex Levin

Last month's article, Prepayment-Risk-and-Option-Adjusted-Spread Valuation, described a new MBS valuation approach that accounts for both the prepayment option and the risk of prepay model being wrong ("prepayment risk"). This new valuation model replaces traditional OAS with a better-defined and known measure, prOAS. We argued that agency MBS should be priced flat to option-free agency debentures, regardless of the coupon (option moneyness) and the cashflow type (pass-throughs, IOs, POs). We distinguished two main risk factors, refinancing understatement and turnover overstatement, and discussed calibration of prices of these risks (that are instrumental for this model) to the TBA market. This article presents historical tendencies, results for the Trust IO market, and uncovered anomalies.

Dynamics of Risk

Will parameters of the prOAS model exhibit stability over time, or do we need to calibrate the model on a daily basis? While a goal of "physical" models is to stay steady, the prOAS approach is built on the idea of risk-neutrality, so it will require contemporaneous market information. Visible OAS tightening and widening over time is sending us a message of changing perception of prepayment risk. This conjecture is borne out by examining the trends in results of the calibration of the prices of risk at different dates, as shown in Figure 1. These parameters are not constant and even show an exaggerated reaction to the interest rate dynamics.

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