Valuing MBS And ABS

Question 0

What are three assumption deficiencies of cash flow yield

Answer 0

CF reinvested at CF yield at pricing
(Reinvestment risk)
MBS held to maturity (price risk)
CFs realized

Question 1

What is cash flow yield

Answer 1

Discount rate equating MBS price to PV of CF (like IRR)

Challenge lies in CF certainty

Question 2

What is nominal spread

Answer 2

Diff between CF yield on MBS and treasury security yield (w/same maturity)

Question 3

Z-spread (zero volatility spread)

Answer 3

Spread added to treasury spot rates to make calc price equate market price

Question 4

What is option adjusted spread

Answer 4

Spread added to every nodal int rate on every int rate path to equate calculated to market price

Question 5

What are limitations of each spread?

Answer 5

Nominal - don’t know portion reflecting prepayment risk

Z - considers one int rate path

Question 6

What are two causes of path dependency

Answer 6

Prepayment burnout (increase at beginning as homeowners refinance, slows down) 
CFs depend on outstanding principal => relies on prepayment history => relies on int rate path

Question 7

How to calc option cost

Answer 7

Option cost = Z-spread - OA spread

Want lower cost option (higher OAS)

Question 8

Which risks does the OAS using treasury benchmark reflect for Ginnae Mae passthroughs?

Answer 8

Liquidity and modelling risk

Not credit risk reflected

Question 9

Which risks does the OAS using treasury benchmark reflect for Ginnae Mae CMOs?

Answer 9

Liquidity (support tranches more than PAC1) and modelling (CMOs> passthroughs)
No credit risk reflected

Question 10

Which risks does the OAS using treasury benchmark reflect for Freddie Mac/Fannie Mae passthroughs?

Answer 10

Small credit risk

Reflects liquidity and modelling risk

Question 11

Which risks does the OAS using treasury benchmark reflect for Freddie Mac/Fannie Mae CMOs?

Answer 11

Small credit risk

Reflects liquidity and modelling risk (CMO support tranches > PAC1)

Question 12

Which risks does the OAS using treasury benchmark reflect for Non agency MBS and real estate backed ABS

Answer 12

Reflects credit, liquidity (more than agency issues) and modelling risk

Question 13

How to identify cheap and rich securities

Answer 13

Cheap = high OAS, low option cost
Rich = low OAS, high option cost 

(Buy cheap, sell rich)

Question 14

What spread to use if security does not have embedded option typically exercised? (Plain vanilla corp, credit card ABS, auto loan ABS)

Answer 14

Z spread

Question 15

What spread to use for securities w/embedded option and CF int rate is path dependent? (MBS, home equity ABS)

Answer 15

OAS from Monte Carlo model

Question 16

What spread to use for securities w/embedded option and CF int rate is NOT path dependent? (Callable corporate)

Answer 16

OAS from binomial model