Valuation of Mortgage Backed Securities: From Optimality to Reality

Abstract

This paper proposes a new valuation procedure of Mortgage Backed Securities (MBS). First, the optimal prepayment policy is obtained thanks to optimal stopping techniques. Then, the fraction of prepaid MBS is assumed to be driven by some characteristic distribution function of the di/erence between the current interest rate and the optimal prepayment frontier. A parametric specification is proposed which allows to easily fit standard market indicators such as the burnout or the Public Securities Association curve. The model is then put into practice and shown to account for most important charasterictics of MBS sensitivities to interest rates markets.

Keywords: Mortgage valuation, Asset Backed Securities

JEL Classification: G12