Additional Market Risk Shocks: Prepayment Uncertainty and Option-Adjusted Spreads

FHFA Working Paper 15-3

24 Pages Posted: 10 Jul 2019

See all articles by Alexander Bogin

Alexander Bogin

Federal Housing Finance Agency

Nataliya Polkovnichenko

Federal Housing Finance Agency

William M. Doerner

Federal Housing Finance Agency

Date Written: July 2015

Abstract

Assessments of market risk for economic or regulatory capital typically involve calculating a portfolio’s sensitivity to key risk factor movements. Historically, practitioners have focused on two classical sources of risk, adverse changes in interest rates and volatility. As stress testing has evolved, additional risk factors have been identified, including several specific to fixed-income securities with embedded optionality. These include changes in prepayment rates or any of several other market risk factors, which affect option-adjusted spreads (OAS). We describe an empirical framework for generating shocks to prepayment rates and mortgage security OAS, which are consistent with simultaneous movements in other key risk factors, including the term structure of interest rates and implied volatility. Our prepayment rate shocks capture model misspecification and are calculated using historical performance data from multiple vendor prepayment models. These shocks are well defined, but capture only a portion of prepayment model error. Mortgage security OAS serves as a broader measure of model error, which encompasses both, model misspecification and forecasting errors as well as credit and liquidity risk. Our OAS shocks are calculated using historical six-month changes in spreads derived from multiple vendor quotes.

Keywords: prepayment, option-adjusted spreads, financial stress testing, capital standards, mortgage, risk management

JEL Classification: G21, G28, G11, E43

Suggested Citation

Bogin, Alexander and Polkovnichenko, Nataliya and Doerner, William M., Additional Market Risk Shocks: Prepayment Uncertainty and Option-Adjusted Spreads (July 2015). FHFA Working Paper 15-3, Available at SSRN: https://ssrn.com/abstract=3416885 or http://dx.doi.org/10.2139/ssrn.3416885

Alexander Bogin (Contact Author)

Federal Housing Finance Agency ( email )

Nataliya Polkovnichenko

Federal Housing Finance Agency ( email )

400 7th Street SW
Washington, DC 20552
United States
202-649-3292 (Phone)

William M. Doerner

Federal Housing Finance Agency ( email )

400 7th Street, SW
Washington, DC 20219
United States
202-649-3218 (Phone)
202-649-2816 (Fax)

HOME PAGE: http://www.fhfa.gov

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