The Pricing of Multi-Class Commercial Mortgage-Backed Securities

Posted: 11 Aug 1995

See all articles by Paul D. Childs

Paul D. Childs

University of Kentucky

Steven H. Ott

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law

Timothy J. Riddiough

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics

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Abstract

This paper considers the pricing of multi-class commercial mortgage-backed securities (CMBS). The predominant security design is a CMO structure in which distinct investment classes (tranches) are prioritized based on the return of principal. Consequently, default risk is shifted to low priority tranches. By employing a contingent-claims analysis that overcomes state variable dimensionality problems, we consider mortgage pools with many distinct collateralizing assets that are less than perfectly correlated with one another and whose loan cash flow values are subject to interest rate uncertainty. Security structure and the correlation structure of collateralizing assets within a pool are found to be important determinants of tranche price and required yield spread. Of particular interest is the finding that reduced cash flow volatility through property diversification may actually decrease the value of the first loss (junior) tranche. When examining the relationship of pool size and tranche value, we find that five to ten distinct mortgages are required to realize a vast majority of the effects of property diversification.

JEL Classification: G13

Suggested Citation

Childs, Paul David and Ott, Steven H. and Riddiough, Timothy J., The Pricing of Multi-Class Commercial Mortgage-Backed Securities. Available at SSRN: https://ssrn.com/abstract=6584

Paul David Childs

University of Kentucky ( email )

College of Business & Economics
Lexington, KY 40506-0034
United States
606-257-2490 (Phone)
606-257-9688 (Fax)

Steven H. Ott (Contact Author)

University of North Carolina (UNC) at Charlotte - Department of Finance & Business Law ( email )

9201 University City Blvd.
Charlotte, NC 28223
United States
704-687-2744 (Phone)
704-687-6987 (Fax)

Timothy J. Riddiough

University of Wisconsin - School of Business - Department of Real Estate and Urban Land Economics ( email )

School of Business
975 University Avenue
Madison, WI 53706
United States
608-262-3531 (Phone)
608-265-2738 (Fax)

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