Learning objectives: Explain the mechanics of different types of agency MBS products, including collateralized mortgage obligations (CMOs), interest-only securities (IOs), and principal-only securities (POs). Describe a dollar roll transaction and how to value a dollar roll. Describe the mortgage prepayment option and factors that affect it; explain prepayment modeling and its four components: refinancing, turnover, defaults, and curtailments. Describe the steps in valuing an MBS using Monte Carlo simulation. Define Option Adjusted Spread (OAS) and explain its challenges and its uses.
Questions:
23.4.1. An investor is evaluating a dollar roll (see below). She may (or may not) roll a $10.0 million balance under the following assumptions: the to-be-announced (TBA) prices of the Fannie Mae 6.0% for June 12th and July 12th settlements are, respectively, $103.00 and $102.25. The short-term interest rate is 2.0% per annum. The expected total (i.e., scheduled plus unscheduled) principal paydown over the month is 1.0%.
About this dollar roll situation, which of the following statements is true?
a. A higher short-term interest rate (aka, repo rate; e.g., from 2.0% to 3.0%) ceteris paribus will increase the value of the roll to the seller
b. A higher short-term interest rate (aka, repo rate; e.g., from 2.0% to 3.0%) ceteris paribus will decrease the value of the roll to the seller because interest is explicitly added to the repurchase price of the back month's (July) pool
c. Because TBA are specified pools, the securities purchased in the back month (i.e., July) will be identical to the securities delivered in June
d. Because principal is passed back to the seller who initiated the roll, a higher principal paydown realization than expected (e.g., 2.0% actual versus 1.0% expected) exposes the seller to actual prepayments during the month
23.4.2. Peter is a new analyst who has been asked to perform a valuation of a mortgage-backed security (MBS) using one of the firm's models. The pool is likely to be stripped into interest-only (IO) and principal-only (PO) strips. Each of the following statements is true EXCEPT which is false?
a. Interest rate uncertainty tends to reduce the value of IOs but increase the value of POs
b. His prepayment model will include an annualized prepayment rate that is likely to predict refinancings according to an incentive function
c. The prepayment rate in his model can be affected (in addition to interest rate levels) by average loan size, average loan age, season (aka, seasonality), and geographical location
d. His preferred model is a recombining tree because the cash flows are path independent because the permutation of up/down jumps prior to arrival at a future interest rate not is irrelevant
23.4.3. The Investment Committee of her firm wants to purchase a mortgage-backed security (MBS). The Committee asked Jane to compare the attractiveness of their two favorite (MBS) pools. One of the committee members requested that she utilize the option-adjusted spread (OAS) in her comparison. Each of the following statements is true EXCEPT which is false?
a. Under a risk-neutral process, the expected return of an MBS security is the short-term rate plus the OAS per period
b. The OAS is a relative value measure such that MBS with an OAS of 90 basis points is probably a better buy than one with an OAS of 30 bps
c. An increase in the MBS' market price increases the OAS by the product of the percentage price change and the reciprocal of the weighted average duration
d. The OAS is the spread (between the discount rate and the applicable Treasury rate) that matches the model's value to the market price of the MBS
Answers here:
Questions:
23.4.1. An investor is evaluating a dollar roll (see below). She may (or may not) roll a $10.0 million balance under the following assumptions: the to-be-announced (TBA) prices of the Fannie Mae 6.0% for June 12th and July 12th settlements are, respectively, $103.00 and $102.25. The short-term interest rate is 2.0% per annum. The expected total (i.e., scheduled plus unscheduled) principal paydown over the month is 1.0%.
About this dollar roll situation, which of the following statements is true?
a. A higher short-term interest rate (aka, repo rate; e.g., from 2.0% to 3.0%) ceteris paribus will increase the value of the roll to the seller
b. A higher short-term interest rate (aka, repo rate; e.g., from 2.0% to 3.0%) ceteris paribus will decrease the value of the roll to the seller because interest is explicitly added to the repurchase price of the back month's (July) pool
c. Because TBA are specified pools, the securities purchased in the back month (i.e., July) will be identical to the securities delivered in June
d. Because principal is passed back to the seller who initiated the roll, a higher principal paydown realization than expected (e.g., 2.0% actual versus 1.0% expected) exposes the seller to actual prepayments during the month
23.4.2. Peter is a new analyst who has been asked to perform a valuation of a mortgage-backed security (MBS) using one of the firm's models. The pool is likely to be stripped into interest-only (IO) and principal-only (PO) strips. Each of the following statements is true EXCEPT which is false?
a. Interest rate uncertainty tends to reduce the value of IOs but increase the value of POs
b. His prepayment model will include an annualized prepayment rate that is likely to predict refinancings according to an incentive function
c. The prepayment rate in his model can be affected (in addition to interest rate levels) by average loan size, average loan age, season (aka, seasonality), and geographical location
d. His preferred model is a recombining tree because the cash flows are path independent because the permutation of up/down jumps prior to arrival at a future interest rate not is irrelevant
23.4.3. The Investment Committee of her firm wants to purchase a mortgage-backed security (MBS). The Committee asked Jane to compare the attractiveness of their two favorite (MBS) pools. One of the committee members requested that she utilize the option-adjusted spread (OAS) in her comparison. Each of the following statements is true EXCEPT which is false?
a. Under a risk-neutral process, the expected return of an MBS security is the short-term rate plus the OAS per period
b. The OAS is a relative value measure such that MBS with an OAS of 90 basis points is probably a better buy than one with an OAS of 30 bps
c. An increase in the MBS' market price increases the OAS by the product of the percentage price change and the reciprocal of the weighted average duration
d. The OAS is the spread (between the discount rate and the applicable Treasury rate) that matches the model's value to the market price of the MBS
Answers here:
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