I’m getting a little confused here… We use OAS to value MBS over nominal spread or CFY because either of the latter two measures have embedded prepayment risk, but we don’t know how much of a % of the total spread IS this prepayment risk. Therefore, we won’t know if a security is undervalued or not. Hence we use OAS (no prepayment option characteristic). But why? My (incorrect) rationale is that by excluded prepayment risk in the discount rate, we are overvaluing MBS. Don’t the cash flows from an MBS need to be discounted at a higher rate because of prepayment risk in the first place? My only rationale otherwise is that we assuming that the prepayment model will adjust the cash flows under Monte carlo for various prepayment scenarios. Thus, we don’t need to include prepayment risk in the discount rate? (because the CFs are already adjusted for prepayment risk) Please help!

this about what a discount rate is, it correlates to the volatility of the underlying CF, while using the OAS you still account for credit and liquidity risk but overall the CF for an MBS/ABS is much more uncertain and volatile, while prepayment plays a role in that, there are other factors, such as stability of underlying collateral and credit quality of borrowers…does this make sense?