Topics 46-51

Question 1

Three exchange functions

Answer 1

Exchange functions fall into three primary categories: product standardization, trading venue, and reporting services.

• Product standardization. Exchanges set the terms of traded, standardized products. Terms include maturity dates, trading price increments, and delivery grades and locations.
• Trading venue. Exchanges may be physical locations or electronic platforms that provide a central location for trading, which then facilities price discovery. Entities trading on an exchange must accept the exchange’s rules and conditions.
• Reporting services. Exchanges report transaction prices to various entities, including trading participants, vendors, and subscribers.

Question 2

Explain the developments in clearing that reduce risk

Answer 2

Clearing is the process of reconciling and matching contracts between counterparties from the time the commitments are made until settlement. Clearing, along with the mechanisms of margining and netting, are important counterparty risk mitigants. Margining involves posting both initial and variation margins. Initial margin represents upfront funds posted to mitigate against counterparty default, while variation margin represents the daily transfer of funds (cash or other assets) to cover position gains and losses. Netting refers to consolidating multiple offsetting positions between counterparties into a single payment.

Direct clearing is a mechanism for bilaterally reconciling commitments between two counterparties. For example, consider a scenario where counterparty X has an agreement to sell 10 contracts at $50 to counterparty Y, and Y has an agreement to sell 10 contracts to X at $55. Instead of exchanging the full 10 contracts and associated payments of $500 and $550, under a direct netting scenario only the net payment o f the $50 difference is paid by X to Y. This type of direct clearing for OTC derivatives is typically called netting, or payment of difference.

A clearing ring is a mechanism to reduce counterparty exposure between three or more exchange members. A clearing ring is voluntary for exchange members. Once members join, however, they must accept the rules of the exchange and must accept each other’s contracts and allow for counterparties to be substituted. For example, if counterparty X is long a contract with counterparty Y, and Y is long the same number of contracts with Z, then Y may be removed from the ring and the two separate obligations would be replaced with a single obligation between X and Z. Clearing rings are designed to mitigate counterparty risk, improve liquidity and facilitate the close-out process. Not all exchange members would benefit from joining a clearing ring. Members that have a single position with another counterparty would not benefit from the ring.

Complete clearing refers to clearing through a central counterparty (CCP). The CCP, which can be either operated directly by an exchange or provided as a service by an independent third party, assumes the contractual obligations o f clearing exchange members and acts as a buyer to sellers and a seller to buyers. By doing so, the CCP reduces counterparty risk and facilitates both clearing and settlement. Complete clearing can be seen as an improvement to a clearing ring since it reduces the risk of member failure and any resulting contagion effect.

CCPs also use margining rules to help protect against counterparty risk. Initial margin involves members pledging upfront funds to offset closeout costs in a member default scenario. Variation margin involves settlement of daily profit and loss of derivatives contracts (mark-to-market process).

Question 3

Compare exchange-traded and OTC markets and describe their uses

Answer 3

Question 4

Identify the classes of derivatives securities and explain the risk associated with them

Answer 4

OTC derivatives comprise of five broad classes: interest rate, foreign exchange, equity, commodity, and credit derivatives.

It is important to note, however, that although interest rate derivatives comprise the majority of the OTC derivatives market, counterparty risk is particularly a concern for certain foreign exchange derivatives (including cross-currency swaps), which typically have long-dated maturities and require the exchange of notional principal. Furthermore, credit default swaps tend to be more volatile and can carry significant wrong-way risk (when the credit quality of the counterparty is inversely related to the level of exposure to the counterparty).

As mentioned, interest rate derivatives dominate the market by gross notional value outstanding of contracts. However, measuring OTC derivatives exposure through gross notional value can be misleading.

Question 5

SPVs benefits and risks

Answer 5

One of the main benefits of SPVs is that they alter bankruptcy rules and transform
counterparty risk into legal risk. The specific legal risk is that the courts may view the SPV and the originating firm as a single legal entity. This is referred to as consolidation, and it would effectively negate the intended benefits of the SPV as a separate, bankruptcy remote legal entity.

Question 6

Derivatives Product Companies (DPCs)

Answer 6

DPCs are set up by firms as bankruptcy remote subsidiaries to originate derivatives products and sell them to investors. Unlike SPVs, however, in order to receive a strong (e.g., AAA) rating they are separately capitalized and have restrictions on their activities and margin. DPCs calculate their internal quantitative risk assessment to quantify credit risk and to make sure they are benchmarked similarly relative to the desired AAA ratings criteria.

A DPCs AAA rating depends on three criteria:

1. market risk minimization through participating on both sides of the market,
2. parent support, with the bankruptcy remote status shielding against the parent’s potential distress, and
3. credit risk and operational risk management through restrictions like limits, margin, and daily mark-to-market.

DPCs used defined triggers for their own failure through a “pre-packaged bankruptcy” process, which lays out the bankruptcy process and is intended to provide a simpler alternative to the standard bankruptcy process. Once a firm enters bankruptcy, DPCs could either continue on as part of another firm, or be terminated.

The advent of alternative AAA-rated entities, the perception that DPCs were inextricably linked to their parents and the loss of credibility in their AAA rating following the global financial crisis essentially rendered DPCs obsolete mechanisms.

Question 7

Monolines and Credit Derivative Product Companies (CDPCs)

Answer 7

Monolines are highly-rated insurance companies that provide financial guarantees, called “credit wraps” to investors. CDPCs are similar to the DPCs, discussed earlier, but have a business model more similar to that o f a monoline.

Monolines and CDPCs are well-capitalized entities with their AAA ratings supported by capitalization requirements based on possible losses and related to the assets for which they provided guarantees. They are generally highly leveraged entities that do not have to post margin. During the recent global financial crisis, several monolines failed (including XL Financial Assurance Ltd., AMBAC Insurance Corporation, MBNA Insurance Corporation), and both monolines and CDPCs, which are considered similar to monolines, fell out of
favor.

Question 8

Lessons Learned from Risk Mitigation (vs. SPVs, DPCs, monolines, and CDPCs)

Answer 8

The history of SPVs, DPCs, monolines, and CDPCs provide the following valuable lessons for CCPs in a central clearing setting:

1. CCPs give priority to OTC derivatives counterparties to the detriment of other parties, including bondholders. This increases the risk in other markets.
2. Relying on a solid legal framework exposes CCPs and exchange members to legal risk. For example, as seen in the case of SPVs and DPCs, courts may change the priority of claims in a bankruptcy scenario, or courts in different jurisdictions may rule in contradictory ways.
3. Although CCPs share similarities with monolines and CDPCs in that they are highlyrated entities set up to manage counterparty risk, CCPs do not take residual risk in the market given that they maintain a matched book of trades. This is in contrast to monolines and CDPCs, which typically have one-way market exposures.
4. In contrast to monolines and CDPCs, which post no variation margin and often no initial margin, CCPs require members to post both initial and variation margin.

Question 9

Provide examples of the mechanics of a central counterparty (CCP)

Answer 9

A central counterparty (CCP) plays an important role in the clearing and settlement of transactions following the initial trade execution. Clearing refers to the processes (including margining and netting) between the period from trade execution until settlement. This period is typically short (a few days or months) for classically cleared non over-the-counter (OTC) derivatives. In contrast, for OTC derivatives this time period could extend to years or even decades. Settlement of a trade occurs when the trade is completed and all payments have been made and legal obligations satisfied.

Loss mutualization is a form of insurance and refers to members’ contributions to a default fund to cover future losses from member defaults. Since all members must contribute to the fund, the potential losses from the default of any given member are contained. When a member does default, any amounts that cannot be covered from the member’s own resources are covered from the fund. Given that losses are spread among surviving members, it is possible that a member will suffer losses even if it never traded with the defaulting counterparty or had no positions with the CCP.

Question 10

Products of CCPs

Answer 10

The OTC derivatives markets include a wide range of products ranging from standard to non-standard and exotic derivatives. There are currently four categories of OTC derivatives according to their stages of central clearing history:

1. Products with a long history of central clearing (e.g., interest rate swaps).
2. Products with a short history of central clearing (e.g., index credit default swaps).
3. Products that may soon be centrally cleared (e.g., interest rate swaptions, credit default swaps).
4. Products that are not suitable for central clearing (e.g., exotic derivatives including Asian options, and derivatives with illiquid reference assets).

The following conditions are important for a product to be centrally cleared:

• Standardization: Legal and economic terms should be standard.
• Complexity: Transactions need to be easily valued for trading and margin purposes, therefore only less complex (i.e., vanilla, not exotic) trades can be cleared.
• Liquidity: Cleared products are typically more liquid than OTC products. Liquidity is important for determining market price for initial margin and default fund contributions, and for the auctioning process. CCPs are also reluctant to develop clearing capability for products that could not be properly cleared due to thin trading. Liquidity also allows for easier close out of trades in a default scenario.

Question 11

Participants of CCPs

Answer 11

Transacting with CCPs is restricted to clearing members only. Becoming a member includes a number of requirements, including:

• Admission criteria: CCPs set different criteria for admission, including restrictions on credit quality (e.g., investment grade only) and size (e.g., minimum $50 million).
• Financial commitment: The primary financial commitment by a member is to contribute to the CCP’s default fund.
• Operational criteria: Members’ operational requirements include posting margin, and participating in “fire drills” to simulate member default and in auctions if default does occur.

Question 12

Number ofCCPs

Answer 12

A single, large CCP may be optimal given the benefits of offsetting trades and cost minimization through economies of scale. However, it is generally not feasible to have a single CCP for the following reasons:

• Regional differences: Regional CCPs may be beneficial to centrally clear trades in the region’s currency and under the laws and regulations of the region.
• Product types: CCPs often specialize in clearing certain derivatives products.
• Regulatory reasons: Regulations may dictate that products be cleared by local CCPs. However, CCPs need not operate in isolation, and CCPs working together may be necessary. It is important to recognize, however, that this may increase systemic risk and the risk of contagion during stress times.

Question 13

Types of CCPs

Answer 13

Arguments exist for both a utility-driven CCP and a profit-driven CCP. A utility-driven
CCP would be focused on long-term stability rather than short-term profits. A profit-driven CCP would be focused on the bottom line in order to attract personnel and build the best systems. Currently, there are stronger arguments in favor of profit-driven CCPs.

Question 14

Describe advantages and disadvantages of central clearing of OTC derivatives

Answer 14

Central clearing through CCPs has the following advantages:

• Transparency: In OTC markets, parties typically do not see all outstanding trades between the various counterparties. CCPs have a consolidated view of trading positions and can therefore better react to extreme events.
• Offsetting: By transacting through a CCP, duplicate bilateral contracts can be offset, which improves flexibility for new transactions and reduces costs.
• Loss mutualization: A member’s losses are distributed among all surviving members, which spread the impact of losses, reduce costs, and minimize market impact and systemic risk.
• Legal and operational efficiency: The centralized role of CCPs in the clearing (margining, netting) and settlement process improves operational efficiency while reducing costs.
• Liquidity: The daily margining of products in a centrally-cleared market ensures greater transparency in product valuation, which increases product liquidity.
• Default management (counterparty risk): CCPs act as the counterparty to each trade, which reduces counterparty risk. Member defaults are centrally managed through the auction process which minimizes price disruptions.

While we noted loss mutualization as an advantage of the central clearing process, it can lead to potential problems, including moral hazard and adverse selection.

• Moral hazard: Moral hazard is the risk that one party will take on higher risk knowing that another party bears the costs of this risk. In central clearing, the risk is that members will have less incentive to monitor risk knowing that the CCP takes on most of the risks.
• Adverse selection: Adverse selection is the risk that participants with a better understanding of product risks and pricing will trade more products whose risks the CCP underprices, and will trade fewer products whose risks the CCP overprices.
• Bifurcation: The separation of trading into cleared and non-cleared products can increase cash flow volatility even for hedged products.
• Procyclicality: Procyclicality essentially reflects the downside of margining. It reflects a scenario where a CCP increases margin requirements (initial margin) in volatile markets or during a crisis, which may aggravate systemic risk.

Question 15

Compare and contrast bilateral markets to the use of novation and netting

Answer 15

The legal process of interposing the CCP between the seller and the buyer is called novation. Through novation, one contract (the bilateral contract between OTC participants) is replaced with another contract (or contracts) with the CCP.

Market participants often prefer to offset rather than to terminate trades, which creates redundant trades. When trades are novated to a CCP, these redundant trades become a single net obligation between each participant and the CCP. This process is called multilateral offsetting, or netting. Netting reduces total risk and minimizes the potential of a domino effect stemming from the default of a participant.

Question 16

Assess the impact of central clearing on the broader financial markets

Answer 16

When a CCP is included in the clearing process, systemic risk in the financial markets is reduced, but can be increased at the same time. Systemic risk is reduced because CCPs reduce counterparty risk by offsetting positions (novation and netting), they provide transparency for the market, and improve liquidity. However, the potential requirement that members post higher initial margin during times of increased market volatility could increase systemic risk. In addition, concentrating all trades in a single place exposes the market to the risk of CCP failure and heightened systemic risk.

Question 17

Identify and explain the types of risks faced by CCPs

Answer 17

• Default Risk
  The default of a clearing member and its flow through effects is the most significant risk for a CCP.
  Passing on losses to other clearing members may result in defaults by
  those members. The loss allocation methods may be considered unfair because some of them, such as variation margin gains haircutting (VMGH) and tear-ups, impose losses on “winning positions.”
• Model Risk
  OTC derivatives are not priced by the market but are instead priced using valuation models that perform the mark-to-market function, which subjects CCPs to model risk.
• Liquidity Risk
  There are large amounts of cash inflows and outflows flowing through the CCP due to initial margins and margin calls.
  There is the risk that the CCP’s investments are not always quickly and easily convertible to cash, which may require some liquidity support from a central bank. In this regard, a CCP is required to have sufficient liquid resources to meet its obligations in the event of the failure of one or two of its largest clearing members. The Basel III leverage ratio (calculated
  as the bank’s tier 1 capital divided by its exposure) requirements serve to minimize the amount of risk taking.Overall, regulations have attempted to address a CCP’s potential liquidity risks; however, they may reduce the availability of clearing services.
• Operational Risk
  Due to the centralization of some functions within a CCP to increase efficiency, additional risks arise that affect counterparties due to concentration at the CCP. CCPs face operational risks that are common to all entities such as business interruption due to information systems failures and internal or external fraud. However, a systems failure within a CCP could have a disastrous impact on many counterparties, especially if they hold large positions.
• Legal Risk
  Legal risks in the form of litigation or claims may arise due to differing laws in different jurisdictions or laws that are inconsistent with the CCP’s regulations.
• Other Risks
  - Investment risk refers to the risk of losses of margin funds resulting from investment actions performed within or outside o f the stated investment policy.
  - Settlement and payment risk refers to the risk that a bank no longer provides cash settlement services between a CCP and its members.
  - Foreign exchange risk refers to the risk of mismatches between margin payments and cash inflows or outflows in different currencies.
  - Custody risk refers to the risk of loss of securities, margins, or both by a custodian due to its failure, fraud, or negligence.
  - Concentration risk refers to the risk of clearing members, margins, or both that are located in a single geographic area. Essentially, it is a lack of diversification.
  - Sovereign risk refers to the risk that a foreign government could default on its debt obligations, thereby causing members to fail. It also refers to any potential loss in the value of sovereign bonds held as margin.
  - Wrong-way risk refers to the risk that exposure to a counterparty is negatively correlated with the credit quality of the counterparty. In other words, it occurs when credit exposure to a counterparty and the default risk of the counterparty increase together.

Question 18

Identify and distinguish between the risks to clearing members as well as non-members

Answer 18

Non-members face exposure from CCPs, clearing members, and other non-members. If a CCP fails, a non-member may be able to avoid losses so long as its counterparty (a clearing member) is solvent. Unlike clearing members, non-members are not required to contribute to default funds so, therefore, non-members are not exposed to losses that result from CCP failures.

Furthermore, the extent of non-members’ losses due to defaults o f CCPs and clearing members lies with the initial margins and whether they are segregated, guaranteed, or both. In addition, non-members face the risk of not being able to port their trades should the counterparty member default. As a result, such trades may have to be closed out at a loss.

Finally, one has to consider non-members’ liability with respect to CCP loss allocation rules. It is possible that clearing members are able to pass on losses to non-members through VMGH or tear-up, which would reduce the gains o f non-members. Clearing members are unable to pass on losses resulting from default fund utilization, rights of assessment, and forced allocation.

Question 19

Identify and evaluate lessons learned from prior CCP failures

Answer 19

There are five key lessons learned from prior CCP failures:

1. Operational risk must be controlled to the maximum extent possible. For example, information systems should be updated sufficiently to be robust enough to handle unusually high trading volumes and to detect significant price changes.
2. Variation margins should be recalculated often and collected quickly (i.e., multiple times a day in certain cases). Having an information system that allows for automated payments could assist in preventing liquidity shortfalls. In addition, having crossmargining linkage arrangements (offsetting of hedged positions) between CCPs may avoid liquidity problems due to the hedging activities of the various CCPs.
3. Initial margins and default funds should be sufficiently large in order to withstand significant negative asset value declines as well as increased return correlations during a crises. The assumptions behind the initial margin computations need to be amended to account for significant changes in the market.
4. CCPs must actively monitor positions, penalize overly concentrated positions, and promptly liquidate or hedge extremely large positions.
5. CCPs must have one or more external sources of liquidity to avoid default due to illiquidity (even though it is still solvent).

Question 20

Calculate a financial institution’s overall foreign exchange exposure

Answer 20

A bank’s actual exposure to any given currency can be measured by the net position exposure. Net exposure is the extent to which a bank is net long (or positive) or net short (or negative) in a given currency. For example, a bank’s net euro (EUR) exposure would be:

net EUR exposure = (EUR assets — EUR liabilities) + (EUR bought — EUR sold)
net EUR exposure = net EUR assets + net EUR bought

A positive net exposure position means that we are net long in a currency. In other words, we hold more assets than liabilities in a given currency. In this instance, the financial institution faces the risk that the foreign currency will fa ll in value against the domestic currency.

A negative net exposure position means that we are net short in a currency. The financial institution faces the risk that the foreign currency will rise in value against the domestic currency.

Question 21

Identify and describe the different types of foreign exchange trading activities

Answer 21

A financial institution’s buying and selling of foreign currencies, and hence the institution’s position in the FX market, reflects four key trading activities:

1. Enabling customers to participate in international commercial business transactions.
2. Enabling customers to take positions in real or financial foreign investments. Note that a financial institution may also transact in foreign currencies to take positions in real or financial foreign investments for its own portfolio.
3. Offsetting exposure in a given currency for hedging purposes.
4. Speculating on foreign currencies in search of profit by forecasting and/or anticipating futures FX rate movements.

For acrivities 1 and 2 the bank typically serves as an agent for the customers
(receives a fee) and does not assume the FX risk itself.

Question 22

On-Balance-Sheet Hedging

Answer 22

On-balance-sheet hedging is achieved when a financial institution has a matched maturity and currency foreign asset-liability book. Figure 2 is an illustration

Question 23

Off-Balance-Sheet Hedging

Answer 23

Rather than matching foreign assets with foreign liabilities, we may choose to remain unhedged on the balance sheet. If we do, we could hedge off-balance-sheet by taking a position in the forward market. This hedge would appear as a contingent off-balance-sheet claim as an item below the net income line.

Rather than repatriating CHF and exchanging them for USD at the end of the period at an unknown rate, the bank can enter into a contract to sell forward the expected principal and interest on the loan at the current known forward exchange rate for USD/CHF, with the delivery of Swiss francs to the buyer of the forward contract taking place at the end of the investment horizon. This method effectively removes the future spot exchange rate uncertainty that is related to
investment returns on the Swiss loan.

Question 24

Describe how a non-arbitrage assumption in the foreign exchange markets leads to the interest rate parity theorem, and use this theorem to calculate forward foreign exchange rates

Answer 24

The hedged dollar return on foreign investments should be equal to the return on domestic investments. IRP implies that in a competitive market, a firm should not be able to make excess profits from foreign investments (i.e., a higher domestic currency return from lending in a foreign currency and locking in the forward rate of exchange).

To remember this formula, note that when the forward and spot rates are expressed as direct quotes (DC/FC), righthand side of the equation also has the domestic (interest rate) in the numerator and the foreign (interest rate) in the denominator.

If we expressed the forward and spot rates as indirect quotes (FC/DC), then the righthand side of the equation would have the foreign (interest rate) in the numerator and the domestic (interest rate) in the denominator. So it’s either domestic over foreign for everything, or foreign over domestic for everything.

IRP can also be stated using continuously compounded rates as follows:

forward = spot x e^{(r_DC - r_FC)T}

Question 25

Explain why diversification in multicurrency asset-liability positions could reduce portfolio risk. Describe the relationship between nominal and real interest rates.

Answer 25

Each domestic and foreign nominal interest rate consists of two components. The first component is the real interest rate, which reflects a given currency’s real demand and supply for its funds. Differences in real interest rates will cause a flow of capital into those countries with the highest available real rates of interest. Therefore, there will be an increased demand for those currencies, and they will appreciate relative to the currencies of countries whose available real rate of return is low.

The second component is the expected inflation rate, which reflects the amount of compensation required by investors to offset the expected erosion of real value over time due to inflation. Differences in inflation rates will cause the residents of the country with the highest inflation rate to demand more imported (cheaper) goods. For example, if prices in the United States are rising twice as fast as in Australia, U.S. citizens will increase their demand for Australian goods (because Australian goods are now cheaper relative to domestic goods). If a country’s inflation rate is higher than its trading partners’, the demand for the
country’s currency will be low, and the currency will depreciate.

The nominal interest rate, r, is the compounded sum of the real interest rate, real r, and the expected rate of inflation, E(i), over an estimation horizon.

exact methodology: (1 + r) = (1 + real r) [l + E(i)]
linear approximation: r ~ real + E(i)

Question 26

Describe a bond indenture and explain the role o f the corporate trustee in a bond indenture

Answer 26

The bond indenture is a document that sets forth the obligation of the issuer and the rights of the investors in the bonds (i.e., the bondholders). It is usually a detailed document filled with legal language. One of the roles of the corporate trustee is to interpret this language and represent the interests of the bondholders.

Question 27

Participating bonds, Income bond

Answer 27

Participating bonds pay at least the specified interest rate but may pay more if the
company’s profits increase.

Income bonds pay at most the specified interest, but they may pay less if the company’s income is not sufficient. In both cases, the conditions for paying more or less than the specified coupon would be set forth in the indenture.

Question 28

Deferred-interest (DIB) bonds and Payment-in-kind (PIK) bonds

Answer 28

Variations o f the zero-coupon bond include the deferred-interest bond (DIB) and the payment-in-kind bond (PIK).

The DIB will not pay cash interest for some number of years early in the life of the bond. That period is the deferred-interest period. During this period, cash interest accrues and is then paid semiannually until maturity or when redeemed.

PIK bonds pay interest with additional bonds for the initial period, and then cash interest after that period ends.

Question 29

Original-issue discount (OID)

Answer 29

A zero-coupon bond’s interest rate is determined by the original-issue discount (OID):

original-issue discount (OID) = face value — offering price

The value of the bond grows each year and thus pays implicit interest, which is a function of the OID and the term-to-maturity.

Question 30

Advantages/disadvantages of zero-coupon bonds

Answer 30

One advantage of zero-coupon bonds is zero reinvestment risk.

A disadvantage is that the bondholder must pay taxes each year on the accrued interest even though no cash is received from the bond issuer.

If the issuer goes into bankruptcy prior to the maturity of a zero-coupon bond, the
bondholders are only entitled to the accrued interest up to that date and not the full face value of the bond. In other words, the zero-coupon bond creditor can only claim the original offering price plus accrued and unpaid interest up to the date of the bankruptcy filing. The bond issuer faces a huge liability with a zero-coupon bond because of the large balloon payment at maturity.

Question 31

Mortgage bonds

Answer 31

Mortgage bonds can be issued in a series in a blanket arrangement. In this case, one group of bonds is issued under the mortgage, and then others are issued later. When earlier issues mature, additional bonds are then issued in their place.

Question 32

Collateral trust bonds

Answer 32

Collateral trust bonds are backed by stocks, notes, bonds, or other similar obligations that the company owns. The underlying assets are called the collateral or personal property. The issuers are holding companies, and the collateral consists of claims on their subsidiaries.

Question 33

Equipment trust certificates

Answer 33

Equipment trust certificates (ETCs) are a variation of a mortgage bond where a particular piece of equipment underlies the bond. The usual arrangement is that the borrower does not actually purchase the equipment. Instead, the trustee purchases the equipment and leases it to the user of the equipment (the effective borrower), who pays rent on the equipment, and that rent is passed through to the holders of the ETCs. The payments to the creditors are called dividends. The trustee pays for the equipment with the money raised from the issuance of the ETCs, usually about 80% of the value of the equipment, and what is effectively a down payment from the user of the equipment. This provides more security to the creditors than that of a mortgage bond. It is especially attractive if the equipment is standardized, as in the case of railroad cars, which provides for easy sale or lease of the equipment in the case the user of the equipment defaults. ETCs are generally considered the most secure type of bond since the underlying assets are actually owned by the trustee and rented to the borrower.

Question 34

Debentures

Answer 34

As noted earlier, debentures are unsecured bonds (i.e., they do not have any assets underlying the issue). Most corporate bonds are debentures and usually pay a higher interest rate for that reason, however, if the company is highly rated and has not issued any secured bonds, then debentures are almost the equivalent of mortgage bonds in that they have a claim on all the assets of the issuer along with the general creditors. If the issuer has issued secured debt along with debentures, the debenture holders have a claim on the assets that are not backing the secured debt. Typically the issuer is restricted to one issue of debentures if there is already secured debt. If there is no secured debt, and the company issues debentures, there is often a negative-pledge clause that says that the debentures will be secured equally with any secured bonds that may be issued in the future.

Question 35

Subordinated debenture bonds

Answer 35

Subordinated debenture bonds have a claim that is at the bottom of the list of creditors if the issuer goes into default. They are bonds that are unsecured and have another unsecured bond with a higher claim above them. This means that the issuer has to offer a higher interest rate on the subordinated debentures.

Question 36

Convertible debentures, exchangeable debentures

Answer 36

Issuers may choose to issue convertible debentures, which give the bondholder the right to convert the bond into common stock. This feature will lower the interest rate paid. The cost to the issuer, however, is the possibility of increased dilution of the stock. A variation of convertible debentures is exchangeable debentures that are convertible into the common stock of a corporation other than that of the issuer.

Question 37

Guaranteed bonds

Answer 37

Bonds issued by one company may also be guaranteed by other companies. These bonds are known as guaranteed bonds. A guarantee does not ensure that the issue will be free of default risk since the risk will depend on the ability of the guarantor(s) to satisfy all obligations.

Question 38

Describe the mechanisms by which corporate bonds can be retired before maturity

Answer 38

A call provision can either be a fixed-price call or a make-whole call.

• Fixed-price call. The firm can call back the bonds at specific prices that can vary over the life of the bonds as specified in the indenture. They generally start out high and decline toward par. Also, for most bonds, the bonds are not callable during the first few years of the issue’s life.
• Make-whole call. In this case, market rates determine the call price, which is the present value of the bond’s remaining cash flows subject to a floor price equal to par value. A discount rate based on the yield of comparable-maturity Treasury securities (usually the rate plus a premium) determines the present value and the bond’s price. The redemption price is the greater of that present value or the par value plus accrued interest.

A sinking fund provision generally means the issuing firm retires a specified portion of the debt each year as outlined in the indenture. The bonds can either be retired by use of a lottery where the owners of the selected bonds must redeem them, or the bonds are purchased in the open market. The purchase of some sufficient amount of equipment in excess of the value of the amount of the bonds to be retired is another action that may satisfy a sinking fund provision.

A maintenance and replacement fund (M&R) has the same goal as a sinking fund
provision, which is to maintain the credibility of the property backing the bonds. The provisions differ in that the M&R provision is more complex since it requires valuation formulas for the underlying assets. The main point is that the provision specifies that the fund must keep up the value of the underlying assets much like a home mortgage specifies the home buyer must keep up the value o f the home. One way to satisfy the provision is to acquire sufficient cash to maintain the health of the firm. That cash can then be used to retire debt.

Tender offers are usually a means for retiring debt for most firms. The firm openly indicates an interest in buying back a certain dollar amount of bonds or, more often, all of the bonds at a set price. The goal is to eliminate restrictive covenants or to use excess cash. If the first tender offer price does not get sufficient interest, the firm can increase its offer price. Firms can also announce that they will buy back bonds based on the price as determined by a certain market interest rate (e.g., the yield to maturity on a comparable-maturity Treasury plus a spread). This lowers interest rate risk for both the bondholders and the bond issuer.

As a final note, the issuing firm may be able to call back bonds if it is necessary to sell assets associated with the bond issue. For example, if the government requires a firm to sell property, but that property is being used as collateral for the bonds, the firm would sell the property and call back the bonds.

Question 39

Differentiate between credit default risk and credit spread risk

Answer 39

Credit risk includes credit default risk and credit spread risk.

Credit default risk is the uncertainty concerning the issuer making timely payments of interest and principal as prescribed by the bond’s indenture.

Credit spread risk focuses on the difference between a corporate bond’s yield and the yield on a comparable-maturity benchmark Treasury security. This difference is known as the credit spread. It should be noted that other factors such as embedded options and liquidity factors can affect this spread; therefore, it is not only a function of credit risk.

A method commonly used to evaluate credit spread risk is spread duration. The duration of the spread is the approximate percentage change in a bond’s price for a 100 basis point change in the credit spread assuming that the Treasury rate is constant. If a bond has a spread duration of 4, for example, a 50 basis point change in the spread will change the value o f the bond by 2%.

Question 40

Describe event risk and explain what may cause it in corporate bonds

Answer 40

Event risk addresses the adverse consequences from possible events such as mergers, recapitalizations, restructurings, acquisitions, leveraged buyouts, and share repurchases, which may escape being included in the indenture. Such events can drastically change the firm’s capital structure and reduce the creditworthiness of the bonds and their value. In order to protect shareholders, a company may include in the indenture a poison put, which can require the company to repurchase the debt at or above par value in the event of a takeover not approved by the board of directors (i.e., a hostile takeover). The purpose of this feature is to protect bondholders, but its effectiveness toward this goal can be misleading in that the acquiring firm may offer a sufficiently high price for the stock so that the hostile takeover becomes friendly. As a result, the poison puts would not be exercised.

Question 41

Define high-yield bonds, and describe types o f high-yield bond issuers and some of the payment features unique to high yield bonds

Answer 41

Businessman’s risk refers to bonds with a rating at the bottom rung of the
investment-grade category (Baa and BBB) or at the top end of the speculative-grade category (Ba and BB).

Fallen angels are another type o f high-yield bond. They are bonds that were issued with an investment-grade rating, but then events led to the ratings agencies lowering the rating to below investment grade. If the issuers are in or near bankruptcy, they are often called “special situations,” which could either pay off if the company recovers or lead to big losses.

Restructurings and leveraged buyouts may increase the credit risk of a company to the point where the bonds become non-investment grade. The new management may pay high dividends, deplete the acquired firm’s cash, and lower the rating of the existing bonds. In this process, the firm may issue non-investment grade debt to pay off the bridge loans taken to finance the acquisition.

High-yield bonds can have several types of coupon structures. There are reset bonds, where designated investment banks periodically reset the coupon to reflect market rates and the creditworthiness of the issuer.

There are also deferred-coupon structures, which include three types:

1. Deferred-interest bonds,
2. Step-up bonds, and
3. Payment-in-kind bonds.

Deferred-interest bonds sell at a deep discount and do not pay interest in the early years of the issue, say, for three to seven years. Step-up bonds pay a low coupon in the early years and then a higher coupon in later years. Payment-in-kind bonds allow the issuer to pay interest in the form of additional bonds over the initial period.

Question 42

Define and differentiate between an issuer default rate and a dollar default rate

Answer 42

The issuer default rate is the number of issuers that defaulted over a year divided by the total number of issuers at the beginning of the year. It is only a proportion of the number of issuers who do fulfill their obligations and does not include a measure of the dollar amount involved.

The dollar default rate is the par value of all bonds that defaulted in a given calendar year divided by the total par value of all bonds outstanding during the year. Over a multi-year period, often-used measures are ratios of cumulative dollar value of all defaulted bonds divided by some weighted-average measure of all bonds issued. One such measure attempts to weight the bonds outstanding by the number of years they are in the market:

(cumulative dollar value of all defaulted bonds)/ [(cumulative dollar value of all issuance) X (weighted average # of years outstanding)]

Another measure simply takes a raw total as shown in the following equation:

(cumulative dollar value of all defaulted bonds) / (cumulative dollar value of all issuance)

Question 43

Lien Status of mortagages

Answer 43

Whether the mortgage is a first lien, a second lien, or a subsequent lien will greatly impact the lender’s ability to recover the balance owed in the event of default. For example, a first lien would give the lender the first right to receive proceeds on liquidation, so from a seniority perspective, a first lien is more desirable than a second lien.

Question 44

Credit Classification of mortgages

Answer 44

Classifying loans between prime and subprime is determined mainly by credit score.

• Prime (A-grade) loans constitute most of the outstanding loans. They have low rates of delinquency and default as a result of low loan-to-value (LTV) ratios (i.e., far less than 95%), borrowers with stable and sufficient income (i.e., front income ratio of no more than 28% of monthly income to service payments relating to the home and back income ratio of no more than 36% for those payments plus other debt payments), and a strong history of repayments (e.g., FICO score of 660 or greater). Home payments include interest, principal, property taxes, and homeowners insurance.
• Subprime (B-grade) loans have higher rates o f delinquency and default compared to prime loans. They could be associated with high LTV ratios (i.e., 95% or above), borrowers with lower income levels, and borrowers with marginal or poor credit histories (e.g., FICO score below 660). High LTV ratios suggest a higher risk of default. Upon issuance, subprime loans are carefully scrutinized by the servicer to ensure timely payments.
• Alternative-A loans are the loans in between prime and subprime. Although they are essentially prime loans, certain characteristics of Alternative-A loans make them riskier than prime loans. For example, the loan value may be unusually high, the LTV ratio may be high, or there may be less documentation available (e.g., income verification, down payment source).

Question 45

Prepayments and Prepayment Penalties in mortgages

Answer 45

Prepayments reduce the mortgage balance and amortization period. They can occur because of the following reasons:

• Home is sold, which requires the mortgage balance to be paid off.
• Refinancing due to lower rates or more attractive loan features elsewhere.
• Partial prepayments by the borrower during the term.

To counteract the negative effects of prepayments, many loans contain prepayment penalties. They are amounts payable to the servicer for prepayments within a certain time and/or over a certain amount. Soft penalties are those that may be waived on the sale of the home; hard penalties may not be waived.

Question 46

Credit Guarantees in mortgages

Answer 46

The ability to create mortgage-backed securities requires loans that have credit guarantees.

Government loans are those that are backed by federal government agencies.

Conventional loans could be securitized by either government-sponsored enterprises (GSEs). For a guarantee fee, these GSEs will guarantee payment of
principal and interest to the investors.

Also known as private label securitizations, non-agency (or non-conforming) MBSs grew along with U.S. home prices over time up to the 2007 credit crisis. The GSEs have restrictions on what mortgages they can guarantee/securitize [e.g., dollar value limit, loanto- value (LTV) ratio limit], which opened up the private label market for those participants willing to take on the risks inherent in nonconventional loans — jumbo loans (mortgage principal balance over the limit) and/or loans with high LTVs.

Question 47

Four important features of fixed-rate, level payment, fully amortized mortgage loans

Answer 47

There are four important features of fixed-rate, level payment, fully amortized mortgage loans to remember when we move on to mortgage-backed securities (MBS):

1. The amount of the principal payment increases as time passes.
2. The amount of interest decreases as time passes.
3. The servicing fee also declines as time passes.
4. The ability of the borrower to repay results in prepayment risk. Prepayments and curtailments reduce the amount of interest the lender receives over the life of the mortgage and cause the principal to be repaid sooner.

Question 48

Factors That Influence Prepayments

Answer 48

Factors That Influence Prepayments

• Seasonality. The summertime is a popular time for individuals to move (and mortgages must be paid out prior to the sale of a home), so it is the period of time with the greatest prepayment risk. Given some time lags, the prepayments often start to appear in the late summer and early fall.
• Age of mortgage pool. Refinancing often involves penalties and administrative charges, so borrowers tend not to do so until several years into the mortgage. Also, it takes some time for borrowers to build up equity and savings to make prepayments and/or attempt to refinance. As a result, the lower the age of the mortgage pool, the less likely the risk of prepayment.
• Personal. Marital breakdown, loss of employment, family emergencies, and destruction of property are commonly cited reasons for prepayments based on personal reasons. It is difficult to assess this type of prepayment risk.
• Housing prices. Property value increases may spur an increase in prepayments caused by borrowers wanting to take out some of the increased equity for personal use. Property value decreases reduce the value of collateral, reduce the ability to refinance, and, therefore, decrease the risk of prepayment.
• Refinancing burnout. To the extent that there has been a significant amount of prepayment or refinancing activity in the mortgage pool in the past, the risk of prepayment in the future decreases. That is because presumably the only borrowers remaining in the pool are those who were unable to refinance earlier (e.g., due to poor credit history or insufficient property value), and those who did refinance have been removed from the pool already. Also, those who made only large prepayments (instead of fully refinancing) in the past would have exhausted their savings to make the prepayment and would require quite some time to do so again in the future.

Question 49

Mortgage pass-through securities

Answer 49

A mortgage pass-through security represents a claim against a pool of mortgages. Any number of mortgages may be used to form the pool and any mortgage included in the pool is referred to as a securitized mortgage. The mortgages in the pool have different maturities and different mortgage rates. The weighted average maturity (WAM) of the pool is equal to the weighted average of all mortgage ages in the pool, each weighted by the relative outstanding mortgage balance to the value of the entire pool. The weighted average coupon (WAC) of the pool is the weighted average of the mortgage rates in the pool. The investment characteristics of a mortgage pass-through are a function of its cash flow features and the strength of its government guarantee.

Because pass-through securities may be traded in the secondary market, they effectively convert illiquid mortgages into liquid securities (as mentioned, this process is called securitization). More than one class of pass-through securities may be issued against a single mortgage pool.

Question 50

Prepayment speed measures

Answer 50

Two industry conventions have been adopted as benchmarks for prepayment
rates: the conditional prepayment rate (CPR) and the Public Securities Association (PSA) prepayment benchmark.

The CPR is the annual rate at which a mortgage pool balance is assumed to be prepaid during the life of the pool. A mortgage pool’s CPR is a function of past prepayment rates and expected future economic conditions.

We can convert the CPR into a monthly prepayment rate called the single monthly mortality rate (SMM) (also referred to as constant maturity mortality) using the following formula:

SMM = 1 - (1 - CPR)^1/12

If given the SMM rate, you can annualize the rate to solve for the CPR using the following formula:

CPR = 1 - (1 - SMM)¹²

An SMM of 10% implies that 10% of a pool’s beginning-of-month outstanding balance, less scheduled payments, will be prepaid during the month.

The PSA prepayment benchmark assumes that the monthly prepayment rate for a mortgage pool increases as it ages or becomes seasoned. The PSA benchmark is expressed as a monthly series of CPRs.

The PSA standard benchmark is referred to as 100% PSA (or just 100 PSA). 100 PSA (see Figure 4) assumes the following graduated CPRs for 30-year mortgages:

• CPR = 0.2% for the first month after origination, increasing by 0.2% per month up to 30 months. For example, the CPR in month 14 is 14(0.2%) = 2.8%.
• CPR = 6% for months 30 to 360.

A particular pool of mortgages may exhibit prepayment rates faster or slower than 100% PSA, depending on the current level o f interest rates and the coupon rate o f the issue. A 50% PSA refers to one-half o f the CPR prescribed by 100% PSA, and 200% PSA refers to two times the CPR called for by 100% PSA.

It is important for you to recognize that the nonlinear relationship between CPR and SMM implies that the SMM for 150% PSA does not equal 1.5 times the SMM for 100% PSA. Also, keep in mind that the PSA standard benchmark is nothing more than a market convention. It is not a model for predicting prepayment rates for MBS. In fact, empirical studies have shown that actual CPRs differ substantially from those assumed by the PSA benchmark.

Question 51

Ways that pass-through securities are traded

Answer 51

The specified pools market identifies the number and balances of the pools prior to a trade. As a result, the characteristics of a given pool will influence the price of a trade. For example, high loan-balance pools, which make better use of prepayment options, trade for relatively lower prices.

The TBA market, which is more liquid than specified pools, involves identifying the security and establishing the price in a forward market. However, there is a pool allocation process whereby the actual pools are not revealed to the seller until immediately before settlement. The characteristics o f the pools that can be used for TBA trades are regulated to ensure reasonable consistency.

Question 52

Describe a dollar roll transaction and how to value a dollar roll

Answer 52

MBS trading requires the same securities to be priced for different settlement dates. A dollar roll transaction occurs when an MBS market maker buys positions for one settlement month and, at the same time, sells those same positions for another month.

Factors that impact dollar roll valuations:

• The security’s coupon, age, and WAC.
• Holding period (period between the two settlement dates).
• Assumed prepayment speed.
• Funding cost in the repo market.

Factors Causing a Dollar Roll to Trade Special

When the price difference/drop is large enough to result in financing at less than the implied cost of funds, then the dollar roll is trading special. It could be caused by:

• A decrease in the back month price (due to an increased number of sale/settlement transactions on the back month date by originators).
• An increase in the front month price (due to an increased demand in the front month for deal collateral).
• Shortages of certain securities in the market that require the dealer to suddenly purchase the security for delivery in the front month, thereby increasing the front month price.

Question 53

Collateralized Mortgage Obligations

Answer 53

Collateralized mortgage obligations (CMOs) are securities issued against pass-through securities (securities secured by other securities) for which the cash flows have been reallocated to different bond classes called tranches. Each tranche has a different claim against the cash flows of the mortgage passthroughs or pool from which it was derived. Each CMO tranche represents a different mixture of contraction and extension risk. Hence, CMO securities can be more closely matched to the unique asset/liability needs of institutional investors and investment managers.

Question 54

Planned Amortization Class Tranches

Answer 54

The most common type o f CMO today is the planned amortization class (PAC). A PAC is a tranche that is amortized based on a sinking fund schedule that is established within a range of prepayment speeds called the initial PAC collar or initial PAC bond.

What makes a PAC bond work is that it is packaged with a support, or companion, tranche created from the original mortgage pool. Support tranches are included in a structure with PAC tranches specifically to provide prepayment protection for the PAC tranches (each tranche is, of course, priced according to the timing risk of the cash flows). If prepayment rates are faster than the upper repayment rate, the PAC tranche receives principal according to the PAC schedule, and the support tranche absorbs (i.e., receives) the excess. If prepayment speeds are below the lower repayment rate, the funds needed to keep the PAC on schedule come from the cash flows scheduled for the support tranche(s). It sh ould be pointed out that the extent of prepayment risk protection provided by a support tranche increases as its par value increases relative to its associated PAC tranche.

There is an inverse relationship between the prepayment risk of PAC tranches and the prepayment risk associated with the support tranches. In other words, the certainty of PAC bond cash flow comes at the expense of increased risk to the support tranches.

When actual prepayments come at a rate that is faster than expected, the support tranches must absorb the amount that is in excess of that required to maintain the repayment schedule for the PAC. In this case, the average life of the support tranche is contracted. If these excesses continue to occur, the support tranches
will eventually be paid off and the principal will then go to the PAC holders. When this happens, the PAC is referred to as a broken or busted PAC, and any further prepayments go directly to the PAC tranche. Essentially, the PAC tranche becomes an ordinary sequentialpay structure.

Question 55

Strips

Answer 55

A distinguishing characteristic of a traditional pass-through security is that the interest and principal payments generated by the underlying mortgage pool are allocated to the bondholders on a pro rata basis. This means that each pass-through certificate holder receives the same amount of interest and the same amount of principal. Stripped MBSs differ in that principal and interest are not allocated on a pro rata basis. The unequal allocation of principal and interest results in a price/yield relationship that is different from that o f the underlying pass-through.

The two most common types of stripped MBSs are principal-only strips (PO strips) and interest-only strips (IO strips). PO strips are a class of securities that receive only the principal payment portion of each mortgage payment, while IO strips are a class that receive only the interest component of each payment.

PO strips are sold at a considerable discount to par. The PO cash flow stream starts out small and increases with the passage of time as the principal component of the mortgage payments grows. The investment performance of a PO is extremely sensitive to prepayment rates. Higher prepayment rates result in a faster-than-expected return of principal and, thus, a higher yield. Since prepayment rates increase as mortgage rates decline, PO prices increase when interest rates fall. The entire par value of a PO is ultimately paid to the PO investor. The only question is whether realized prepayment rates will cause it to be paid sooner or later than expected.

In contrast to PO strips, an IO strip cash flow starts out big and gets smaller over time. Thus, IOs have shorter effective lives than POs.

The major risk associated with IO strips is that the value of the cash flow investors receive over the life of the mortgage pool may be less than initially expected and possibly less than the amount originally invested. Why? The amount of interest produced by the pool depends on its beginning-of-month balance. If market rates fall, the mortgage pool will be paid off sooner than expected, leaving IO investors with no interest cash flow. Therefore, IO investors want prepayments to be slow.

An interesting property of an IO is that its price has a tendency to move in the same direction as market rates. When market rates decline below the contract rate and prepayment rates increase, the diminished cash flow usually causes the IO price to decline, despite the fact that the cash flows are discounted at a lower rate. As interest rates rise above the contract rate, the expected cash flows improve. Even though the higher rate must be used to discount these improved cash flows, there is usually a range above the contract rate for which the price increases.

Both IOs and POs exhibit greater price volatility than the pass-through from which they were derived. This occurs because IO and PO returns are negatively correlated (their prices respond in opposite directions to changes in interest rates), but the combined price volatility o f the two strips equals the price volatility o f the pass-through.

The price/yield relationships for IO and PO securities are shown in Figure 6. Notice the following:

• The underlying pass-through security exhibits significant negative convexity.
• The PO exhibits some negative convexity at low rates.
• The IO price is positively related to mortgage rates at low current rates.
• The PO and IO prices are more volatile than the underlying pass-through.

Question 56

Media effect in MBSs

Answer 56

Historically, if mortgage rates fall by more than 2%, refinancing activity increases dramatically. This is known as the media effect because large declines in rates will likely gain the attention of the media.

Question 57

Cash-out refinancing in MBSs

Answer 57

Extracting home equity is another motive for refinancing a mortgage. Given a substantial increase in property value, a borrower may take out a new mortgage with a higher balance that not only pays off the existing mortgage but also has extra cash for other purposes. Extracting home equity is also known as cash-out refinancing.

Question 58

Refinancing burnout in MBSs

Answer 58

The path that mortgage rates follow on their way to the current level affects prepayments through refinancing burnout. To better understand this phenomenon, consider a mortgage pool that was formed when rates were 12%, then interest rates dropped to 9%, rose to 12%, and then dropped again to 9%. Many homeowners will have refinanced when interest rates dipped the first time. On the second occurrence of 9% interest rates, most homeowners in the pool who were able to refinance would have already done so.

Question 59

Housing turnover in MBSs

Answer 59

It is typically the case that the mortgage is due once the property is sold. This is referred to as due on sale. Because most borrowers sell their homes without regard for the path of mortgage rates, MBS investors will be subjected to a degree of housing turnover that does not correlate with the behavior of rates. One factor that slows the degree of housing turnover is known as the lock-in effect. This essentially means that borrowers may wish to avoid the costs o f a new mortgage, which likely consists of a higher mortgage rate.

Modeling turnover typically starts with a base rate and then adjusts for seasonality (turnover is higher in the summer and lower in the winter). The turnover model may also include a seasoning ramp, which is partially based on improvements to creditworthiness over time, and, thus, the homeowner’s increased ability to prepay the mortgage. As a group, housing turnover only accounts for 10% of overall prepayments.

Question 60

Curtailments in MBSs

Answer 60

Partial payments by the borrower are referred to as curtailments. These partial payments tend to occur when a mortgage is older or has a relatively low balance. Thus, prepayment modeling due to curtailment typically takes into account the age of the mortgage.

Question 61

Usage of the binomial model in evaluation MBSs

Answer 61

The binomial model is only applicable for securities where the decision to exercise a call option is not dependent on how interest rates evolve over time. While the binomial model is useful for callable agency debentures and corporate bonds, it is not applicable to valuing an MBS. The historical evolution of interest rates over time impacts prepayments and makes the binomial model inappropriate for MBSs.

Question 62

Steps required to value a mortgage security using the Monte Carlo methodology

Answer 62

The following steps are required to value a mortgage security using the Monte Carlo methodology:

1. Simulate the interest rate path and refinancing path.
2. Project cash flows for each interest rate path.
3. Calculate the present value of cash flows for each interest rate path.
4. Calculate the theoretical value of the mortgage security.

Question 63

Define Option Adjusted Spread (OAS) and Z-spread

Answer 63

The option-adjusted spread (OAS) is defined as the spread, K, that, when added to all the spot rates of all the interest rate paths, will make the average present value of the paths equal to the actual observed market price plus accrued interest.

The OAS can be interpreted as a measure of MBS returns that indicates the potential compensation after adjusting for prepayment risk. In other words, the OAS is option adjusted because the cash flows on the interest rate paths take into account the borrowers’ option to prepay.

The zero-volatility spread (z-spread) is a spread measure that an investor realizes over the entire Treasury spot rate curve, assuming the mortgage security is held to maturity. It is a more accurate measure because it compares an MBS to a portfolio of Treasury securities. The zero-volatility spread is the yield that equates the present value of the cash flows from the MBS to the price of the MBS discounted at the Treasury spot rate plus the spread. Thus, an iterative process is
required to determine the zero-volatility spread.

The zero-volatility spread accounts for variations in MBS principal payments at a given prepayment rate or speed. However, it does not consider the impact that prepayment risk or changing prepayment rates have on the value of the MBS.

option cost = zero-volatility spread — OAS

Therefore, the option cost is a by-product of the Monte Carlo analysis and is not
determined using traditional option value approaches. As volatility declines, the option cost decreases, and the previously described relationship suggests that OAS increases as volatility declines, all other things equal.

Question 64

OAS Challenges

Answer 64

There are four important limitations to consider when using OAS:

• Modeling risk associated with Monte Carlo simulations.
• Required adjustments to interest rate paths.
• An underlying assumption of a constant OAS over time in the model.
• The dependency of the underlying prepayment model.

The OAS is generated through Monte Carlo simulations. Therefore, the OAS is subject to all modeling risks associated with the simulation.

The prepayment model is very complex, given the amount of uncertainty regarding important variables. The behavior of both borrowers and lenders changes over time. Thus, the greatest weakness of using OAS valuation estimates generated from the Monte Carlo simulation is the dependence on the prepayment model.

Additionally, both z-spreads and OAS measures assume the securities are held to maturity. Some investors may hold a security to maturity, but many investors will only hold a security over a finite horizon. Thus, the investor should analyze the securities in a manner that is consistent with the investor’s asset management horizon.