Ch5 Mortgage Backed Securities(2)

4. Valuation Models
4-1. Static Cash Flow Model
Assumption
Prepayment rates can be predicted as a function of the age of the mortgages in a pool.
*prepayment rate increases gradually with mortgage age and then levels of at some constant prepayment rate

Process
Step 1: Computer the (static) cash flow yield, given the set of (static) cash flow & a market price
Step 2: Measure the nominal spread; comparing the cash flow yield on an MBS with that on comparable bonds.

Advantages
*simple to use
- Allowance for the calculation of YTM
- Prepayment is solely a function of mortgage age and future cash flows can be forecasted

Two severe problems
- the model is not pricing model: CFs of mortgage are not fixed owing to prepayments & etc -> they do not specify appropriate yield for a mortgage
- the model provide misleading price-yield and duration-yield curves since cash flows are not fixed

4-2. Implied Models
The model estimate the interest rate sensitivity of MBSs.

Assumptions
Mortgage sensitivity changes gradually over time.

Advantage
More advanced than the static cash flow model that uses YTM

Disadvantages
- They are not true pricing models.
- Mortgage sensitivity can change dramatically over time

4-3. Prepayment Models
More sophisticated models that actually employ two separate models: a turnover model & refinancing model
*historical information + prepayment function

- incentive functions: modeling refinancing activity based on the term structure of interest rates; lagged rates = past interest rates

Non-interest-rate factors
- Mortgage age
- Points paid
- Amount outstanding
- Season of the year
- Geopraphy