Journal of Portfolio Management, Vol. 23, No. 1, Fall 1996
18 Pages Posted: 26 Jun 1998 Last revised: 30 Apr 2011
Date Written: May 9, 1996
Valuation of mortgage backed securities (MBS) using option theoretic methods presents some puzzles. First, the option adjusted spreads (OASs) of passthroughs are significantly larger than the spreads of agency debt, even though they are comparable credits. Second, the OASs of interest only (IO) and principal only (PO) strips are typically very different from those of the passthroughs they were created from - IOs generally have large positive OASs while POs have negative OASs. These results are inconsistent with the no-arbitrage principle which underlies the valuation model. I argue in this paper that these puzzles arise from our failure to properly account for the market's pricing of risk due to changes in prepayments unrelated to interest rate changes. I also demonstrate that it is possible to construct a prepayment model inferred purely from market prices of MBS which, when used in a standard valuation model, automatically takes account of the market price of prepayment risk. A theoretical motivation is provided for the construction of this model.
JEL Classification: G12, G13
Suggested Citation: Suggested Citation