Caring is sharing: Valuation of MBS/ABS

Answer TRUE/FALSE and explain why: 1. The nominal spread is the cash flow yield minus the yield on a treasury security with the same stated maturity 2. A limitation of the cash flow yield is that ’ prepayments always affect the projected cash flows and hence the value of the security’ 3. An MBS is interest rate path dependent: this can be explained using the monthly cash flows into a CMO tranche and how it depends on outstanding balanced of other tranches in the security. 4. The collateral of a CMO sells at a premium and is made up of a well-diversifed pool of passthroughs. A slow down in prepayments will tend to decrease the value of the collateral. Caring is sharing…

(TRUE)^4 ?

  1. False: use average life due to prepayments 2. True 3. True I think 4. False: why would prepayments affect the collateral Not overly confident, but I think they are right.

I was rushed this morning and as soon as I got into the car I thought “idiot.” For some reason I thought the collateral was the actual real estate. Last one is true.

Niblita75 Wrote: ------------------------------------------------------- > I was rushed this morning and as soon as I got > into the car I thought “idiot.” For some reason I > thought the collateral was the actual real estate. > Last one is true. I still think 4 is false. If you get extended on a premium bond the value shouldn’t go down (think about receiving an above market coupon for a longer time period).

I agree that 4 is false.

What about extension risk? I am guessing that your guy’s reasoning has something to do with the premium. Either way, I had a bank in shot answering the question with my first post haha.

Folks, sorry it has taken me time to share the answers for these questions 1. The nominal spread is the cash flow yield minus the yield on a treasury security with the same stated maturity Ans: False: The convention is to determine the nominal spread relative to the spread on a Treasury security with THE SAME MATURITY AS THE AVERAGE LIFE of the MBS 2. A limitation of the cash flow yield is that ’ prepayments always affect the projected cash flows and hence the value of the security’ Ans False: It is only when prepayments (and/or default/receovery) is are different from that assumed , that the cash flows and hence the cash flow yield will be different. 3. An MBS is interest rate path dependent: this can be explained using the monthly cash flows into a CMO tranche and how it depends on outstanding balanced of other tranches in the security. True: There are two sources of path dependency in a CMO tranche’s cash flows: first prepayments as it relates to interest rates falling leading to refinancing , then rising and falling with minimal refinancing because of prepayment burnout. Second. The cash flows to be received in the current month by a CMO tranche depend on the outstanding balances of the other tranches in the deal. 4. The collateral of a CMO sells at a premium and is made up of a well-diversified pool of passthroughs. A slow down in prepayments will tend to decrease the value of the collateral. False: Since the collateral is trading at a premium, a slowdown in prepayments will allow the investor to receive the higher coupon for a longer period of time. This will increase the value of the collateral.