Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques

EVALUATING INVERSE FLOATERS

Evaluating complex securities such as inverse floaters and inverse IOs presents special challenges to investors. As discussed in Chapter 7, these bonds are created from either a collateral pool or, more commonly, from a collateral or “parent” tranche. In addition, their coupons are both variable and, especially for “payer” inverses, leveraged with respect to changes in the reference rate or index. Before addressing some valuation techniques, it will be helpful to establish a framework for understanding and conceptualizing the bonds in an economic context.

Since both the inverse floater and floating rate tranche are created from a fixed rate parent tranche, the following relationship is true:

Long a fixed rate parent tranche = Long a capped floater + Long an inverse floater

(As discussed in Chapter 7, the floater must be capped, since the parent tranche has a fixed coupon rate.)

Recasting this relationship in terms of an inverse floater gives us

Long an inverse floater = Long a fixed rate parent tranche - Long a capped floater

Or, equivalently,

Long an inverse floater = Long a fixed rate parent tranche + Short a capped floater

Thus, the owner of an inverse floater has effectively purchased a fixed rate tranche and shorted a capped floater. However, shorting a floater is equivalent to borrowing funds, where the interest cost of the funds is a floating rate and the floating rate is the reference rate plus the spread. Consequently, the owner ...