With MBS I know you want ones with high OAS and low option cost. This might be a stupid question, but what is the option its referring to? Is it the prepayment risk? I know for corporate bonds its the option for the company to call the bond from you or for you to put the bond to them. For convertible bonds its the ability to convert the bonds to stock. So what option are you talking about with MBS?
Yes, the prepayment optionality embedded in the MBS underlier.
In other words… You, the homeowner, have the option to pay early on your mortgage. And the prevailing interest rates, housing turnover, and one more thing I can’t remember will determine whether or not you will “exercise” your prepayment option. So as a result, the lender needs to be compensated for that prepayment risk thus a higher interest rate is required. And through securitization of the mortgage, the investors in the MBS are compensated for that risk as well. I think this makes sense, but people feel free to correct if I’m wrong.
a MBS is basically like a callable bond, where the borrower (home owners) can call (by prepaying and re-financing at a lower rate) if the rate drops. So, it is a bond with embedded option.
CF_AHHHHHHHHH Wrote: ------------------------------------------------------- > In other words… > > You, the homeowner, have the option to pay early > on your mortgage. And the prevailing interest > rates, housing turnover, and one more thing I > can’t remember will determine whether or not you > will “exercise” your prepayment option. > > So as a result, the lender needs to be compensated > for that prepayment risk thus a higher interest > rate is required. And through securitization of > the mortgage, the investors in the MBS are > compensated for that risk as well. > > I think this makes sense, but people feel free to > correct if I’m wrong. The general health of the conomy will usually affect prepayment speed. Also, since MBS is path-dependent, the past interest rate will determine the prepayment pattern. Whereas a regular callable bond is only affected by the current rate.
" one more thing I can’t remember will determine" - is seasonal and local economics i.e. Characteristics of the underlying mortgage
Lately, the owner’s option to say F*** it and walk away from an underwater mortgage is also being priced into MBS.
@dl: this was an option many got for free too, the CFAI has a whole section on how home buyers got a free call option on the value of their home, an option as you say many are exercising now!