CFAI V5 462, When prepayment speed is slower(faster), the OAS increases(decreases). Why is that? My logic is that since OAS measures credit and liquidity risk, if prepayments speed increases, the collateral is less likely to default, therefore less risk, lower spread. Is this correct? Would this be the same if the MBS was trading at a discount?
How do you know that the increased prepayments are not coming from defaults (e.g. foreclosures)? Or, coming from refinances in a declining interest rate environment…hence reinvestment risk?
yickwong Wrote: ------------------------------------------------------- > CFAI V5 462, > > When prepayment speed is slower(faster), the OAS > increases(decreases). Why is that? My logic is > that since OAS measures credit and liquidity risk, > if prepayments speed increases, the collateral is > less likely to default, therefore less risk, lower > spread. > > Is this correct? > > Would this be the same if the MBS was trading at a > discount? The logic seems fine to me. Or non-intuitive way to look at this would be to use the equation option cost = zspread - oas As preypayment increase so would the option cost to the investor. The Z spread, of a theoretical non option MBS would be constant (prepayments would not apply, since the option does not exist). So oas would have to decrease.
wyantjs Wrote: ------------------------------------------------------- > How do you know that the increased prepayments are > not coming from defaults (e.g. foreclosures)? Or, > coming from refinances in a declining interest > rate environment…hence reinvestment risk? Wyantjs, how would prepayments increase from defaults? Could you please elaborate? As for reinvestment risk, i’m not sure if the spread measures it, i.e. Z spreads measure liquidity, credit and option risk, while OAS measures liquidity and credit risk.
Well…in the case of MBS…default on mortgage -> foreclosure -> bank repo -> bank sells property on courthouse steps -> principle repaid on loan -> principle received by investor before expected -> prepayments due to default. Z spreads certainly have some component of reinvestment risk built in. CFAI will tell you that it is some rigid combination of liquidity and credit risks, but the truth is that spreads include views on all kinds of risks.