The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies, Second Edition

VALUATION OF MBS AND ABS

Now we will demonstrate how to value mortgage-backed and asset-backed securities. We begin by reviewing the conventional framework—static cash flow yield analysis—and its limitations. Then we discuss a more advanced technology, the Monte Carlo model and a by-product of the model, the OAS analysis. The static cash flow yield methodology is the simplest of the two valuation technologies to apply, although it may offer little insight into the relative value of a mortgage-backed or asset-backed security. The option-adjusted spread technology while far superior in valuation is based on assumptions that must be recognized by an investor and the sensitivity of the security’s value to changes in those assumptions must be tested.

Static Cash Flow Yield Analysis

As explained in the previous chapter, the yield on any financial instrument is the interest rate that makes the present value of the expected cash flow equal to its market price plus accrued interest. For mortgage-backed and asset-backed securities, the yield calculated is called a cash flow yield. The problem in calculating the cash flow yield of a mortgage-backed and asset-backed security is that because of prepayments (voluntary and involuntary) the cash flow is unknown. Consequently, to determine a cash flow yield some assumption about the prepayment rate must be made.

The cash flow for a mortgage-backed and asset-backed security is typically monthly. The convention is to compare the yield on ...