Evaluate MBS using OAS spread analysis ( LOS 53.e)

CFA Level II
#21

You’re good.

It really make sense now.

Z-spread is 1 interest rate / prepayment ( the actual ) path, which imply zero volatility in the CFs.

OAS add up the interest rate volatility and the impact of this volatility on prepayment , price every path and take the average. this is not really what you will earn, but in average, you should earn that spread. theoretically you will be in one of the path you have simulated and earn that specific path spread.

since Z-spread does not look at influence of the interest rate volatility on the prepayment option, then the diffenrence between those two is the price of the issuer behavior given the interest rate.

i would go further and say that since the z-spread is the base scenario, all simulated scenario with higher interest rate will result in a quite similar spread than the Z spread ( if not the same… maybe less prepayment than expected but very very similar ). and all the simulated scenario with lower interest rate will have lower spread.

So you can easly see that the simulated distribution of the spread will be well skewed to the left of the Z-spread ( mch more scenario with lower spread than the Z spread ). So the difference between the Z spread and average spread in the sim path ( OAS ) really represent the effect of bad scenarios.

So yes, I would prefer to hold a High average spread and a low option cost since this will give me confidence in the certainty of the spread i will earn and a low negative volatility on the spread.

thanks Kedgar

#22

Thanks Kedgar

#23

Closer.

Why does the cash flow vary? because of a curtailment or loan Payoff.

What influences the variability of the cash flow…? Interest Rates.

If rates decline, i have an incentive to refinance my home and save money OR move to larger home and have same payment, So I sell my home. To complicate matters, Home sales decline in low rate enviroments…why? Rates decline in bad economy. In good economy, rates rise, incomes are up, people move for jobs and larger homes.

So the Modeling exercise is to determine using a prepayment model an estimate of prepayments based upon the variability of interest rates. Prepayments are not fully dependent on interest rates, but higly correlated. During rising rate enviroments, prepayments slow significantly.

For 200 paths, central limit theorem comes into play and that you should get a normal distribution. (this might be lognormally distributed bounded by zero since rates >0 (need to verify), The interest rate Vol comes into play by having a wider dispersion of the Paths, which will determine how sensitive the security is to changes in rates and ultimately the amount of prepayments realized which shortens or extends the bond. This is where the effective Duration comes into play. Duration is for one path, and the effective duration takes into consideration changes in rates. For this reason duration is useless on MBS and you need effective duratrion.

With Respect to your comment on lower rates–lower spread, you are ignoring the possibility that you might own a bond like a PO at a big discount to par and if rates decline and the bond is highly callable and pays off(like a support bond will that is protecting the senior PAC’s), then the spread will be massive. in english, you own a bond at 40.00, rates decline and prepayments accelerate. what happens to Duration? shortens. What happens to balance? Pays down. What is your profit? big. That is why the bonds are “Path Dependent” . technically, Prepayments are influenced, not fully dependent. If so, Correlation would be 1 to rates and they are not.

Your statement on INT vol is off… The CF on the Security is the Interest Payment + prepayment. OAS is the spread the equates the PV of the bonds Cashflow_t at Spot rate_t, all added up and averaged to a GIVEN Price. All the Int Vol does widen/narrow the independent Paths…

Path 1 — PV cash flows generated to SPOT rates for a given price, then determine the Spread to Spot, then average all spreads. (poorly worded, read def)

I didn’t realize how much I actually new about this until someone asked me…