When calculating the Z-Spread for an MBS/CMO, how does one go about estimating the cash flows of the security? In other words, does one simply assign a prepayment rate assumption (e.g. 100 PSA or 150 PSA) to the security, which in turn is used to estimate that cash flow stream?
The Cah flows related to MBS/ABS are estimated using Monte carlo simulation where you put in various inputs like volatility,Spot rates etc and then generate a series of Cash flows that can be used to value MBS.
Thanks for the response. As I understand it, the Monte Carlo simulation is used to calculated the Option-Adjusted Spread (OAS), NOT the Z-Spread. The Z-Spread assumes zero volatility (Z-spread is short for "Zero Volatility Spread) and thus is not a good spread measure for valuing MBS/CMOs because those securities have signifcant prepayment risk and are dependent on the path of interest rates. Since the Z-spread only considers one path of interest rates (the current spot curve), it is better to use OAS (which considers various paths of interest rates thru Monte Carlo). But since you need the Z-spread to derive the Option Cost (Z-spread - OAS = Option Cost), I was wondering if anybody new how the cash flows were estimated to determine the Z-Spread? The current spot curve will be used, and the task is to find the spread that when added to the spot curve forces the theoretical price to equal the current market price. So how does one go about estimating the series of cash flows used to calculate this? Thanks.