I can’t seem to figure out how to compare relative prices of different MBS tranches using OAS, zero-volatility spreads, effective duration, etc. I’d appreciate help with that.
The OAS spread is the spread over treasury spot rates that will make the expected cash flows equal to the current market price of the MBS. For a given duration two similar MBSs should have about the same z spreads and OASs. If one of the MBSs has a larger OAS than the other than it is realively underpriced and we should go long. This stuff is hard to think about. I doubt this helped.
that was a great start, mwvt. That’s a really hard problem for me. thanks for your help.
Which of the following statements is correct concerning the collateralized mortgage obligation (CMO) tranches shown in the following figure? tranche-------OAS-------Zspread--------effective duration --1-------------68------------85---------------------2.6 --2-------------71 -----------91---------------------2.9 --3-------------73-----------136--------------------8.25 A. Tranches 2 and 3 are relatively less expensive than Tranche 1. B. Tranches 1 and 2 are relatively less expensive than Tranche 3. C. Tranches 1 and 3 are relatively less expensive than Tranche 2. D. Tranches 1, 2, and 3 are approximately the same value.
One other way to think about this is the the OAS spread removes the optionality of the cash flows for the MBS. So it is the spread you are getting for credit, liquidity and modeling risk. So you always want a bigger OAS for a given Z spread and duration.
In the above, the option costs are: Tranche 1 = 17 (85-68) Tranche 2 = 20 (91-71) Tranche 3 = 63 (136-73) First thing to notice is that all three tranches offer similar OAS. Tranche 3 clearly has the highest option cost. Finally, if you look at effective duration, tranche 3 has much higher interest rate risk, but the same OAS as the other two tranches.
B… the option cost on 3 is really large.
option cost 1) 17 2) 20 3) 63 it seems like 1 and 2 are relatively more expensive than 3 -> B However, it’s understandable that option cost of the third tranch is higher because of higher effective duration.
B?
You have to look at the OAS too. You want the biggest OAS you can get. You have the same OAS as the others, but a lot more interest rate risk in tranche 3.
So in the above case OAS as well as option cost should increase with effective duration or average life. In case of Tranche 3 it seems the increase for option cost is higher than expected leading to lower OAS than expected. Since Tranche 3 has lower than expected OAS hence it is relatively expensive when compared to Trance 1 and Tranche 2 So the answer should be B. Is this correct?
what should be fair OAS for the third tranche though?
I have no idea, but I would toss out a number of over 100 bps.
for given duration, the higher OAS, the high price?
Here’s another: In general, the investment team at Matrix attempts to buy “cheap” securities because they are undervalued on a relative basis. What is a characteristic of a “cheap” security for a given Z-spread and effective duration? A) Low OAS relative to the required OAS and low option costs. B) High OAS relative to the required OAS and high option costs. C) Low OAS relative to the required OAS and high option costs. D) High OAS relative to the required OAS and low option costs.
maratikus Wrote: ------------------------------------------------------- > what should be fair OAS for the third tranche > though? tranche-------OAS-------Zspread--------effective duration --1-------------68------------85---------------------2.6 --2-------------71 -----------91---------------------2.9 --3-------------73-----------136--------------------8.25 If you create ratios 1 (85-68)/2.6=6.538 2 (91-71/2.9=6.896 3 (136-73)/8.25=7.63 So to force trance 3 to about 6.7 (136-X)/8.25=6.7 X=80.725 I don’t know if this works. I just made it up.
Niblita75 Wrote: ------------------------------------------------------- > Here’s another: > > In general, the investment team at Matrix attempts > to buy “cheap” securities because they are > undervalued on a relative basis. What is a > characteristic of a “cheap” security for a given > Z-spread and effective duration? > > A) Low OAS relative to the required OAS and low > option costs. > > B) High OAS relative to the required OAS and high > option costs. > > C) Low OAS relative to the required OAS and high > option costs. > > D) High OAS relative to the required OAS and low > option costs. D.
D i guess
Niblita75 Wrote: ------------------------------------------------------- > Here’s another: > > In general, the investment team at Matrix attempts > to buy “cheap” securities because they are > undervalued on a relative basis. What is a > characteristic of a “cheap” security for a given > Z-spread and effective duration? > > A) Low OAS relative to the required OAS and low > option costs. > > B) High OAS relative to the required OAS and high > option costs. > > C) Low OAS relative to the required OAS and high > option costs. > > D) High OAS relative to the required OAS and low > option costs. D
definitely D mwvt, I like what you made up but I wonder if there is a standard way.