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Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques by WILLIAM S. BERLINER, ANAND K. BHATTACHARYA, FRANK J. FABOZZI

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VALUATION USING MONTE CARLO SIMULATION AND OAS ANALYSIS

While the Z-spread is a more realistic measure of relative value than the nominal spread measure, it also does not account for the impact of prepayments, and changing prepayment rates, on the value of the MBS. While the borrowers’ ability to prepay is an option, it cannot be valued directly using traditional option valuation techniques. Rather, the value of this option, and the value of securities containing this type of embedded option, must be derived using complex alternative methodologies. This section is not intended as an in-depth technical description of the processes. It should rather serve as an introduction to the techniques, allowing the user to understand and interpret the output of the models, as well as the assumptions underlying the methodologies.
In fixed income valuation modeling, there are two methodologies commonly used to value securities with embedded options—the binomial model and the Monte Carlo model. The latter model involves simulating a sufficiently large number of potential interest rate paths in order to assess the value of a security along these different paths. This model is the most flexible of the two valuation methodologies for valuing interest rate sensitive instruments where the history of interest rates is important. MBS are commonly valued using this model. As explained below, a byproduct of a valuation model is the OAS.
The binomial model is used to value callable agency debentures ...

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