Changes to the Market Analysis Framework

Starting October 4, 2002, we have begun using version 5.1 of the Andrew Davidson & Co. OAS model for our Market Analysis. The most significant change to the OAS model is the incorporation of version 3.1.1 of the Andrew Davidson & Co., Inc. Interest Rate Process. This version of the Rate Process represents a significant change to its predecessor, including the addition of two new models, namely the Hull-White and the Squared Gaussian. Additionally, the existing the Black-Karasinski process has been enhanced. In contrast to the previous version, which could only be run with a constant volatility, version 3.1.1 can now use time-dependent volatility. The volatility and mean reversion can be quickly calibrated to implied swaption volatilities observed in the market.

We chose to use the Hull-White process for our market analysis because analysis of the derivatives market has shown that a normal model is the best choice for valuing mortgages (see the September 2002 Quantitative Perspectives for more information). We use time-dependent volatility, which we calibrate, along with mean reversion to the at-the-money swaption market. This gives us the best possible fit to the market's volatility structure. For clients who choose to use a different model, we also calibrate the Black-Karisinski and Squared Gaussian Models to the market. We use time-dependent volatility for the calibration and print out the single volatility number that, if held constant, would come closest to matching the calibrated time-dependent volatility. These numbers can be found in the Equivalent Volatility Constants section of the market analysis.