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Opportunities for arbitrage.
(ProQuest Information and Learning: ... denotes formulae omitted.)
Option-adjusted spread (OAS), while a much better measure than yield or static spread, still falls short in explaining the dynamics of mortgage pricing. The standard OAS typically varies across instruments (pass-throughs, collateralized mortgage obligations, interest-only securities, principal-only securities), coupons, prepayment option moneyness, and pool seasoning stages.
Premium and discount MBS are often priced at wider OAS than the current-coupon issues. Premium MBS and IOs stripped ofFpremium pools are considered hazardous, and their higher OAS reflect concerns of understated refinancing. Naturally, the respective POs look rich. In the discount sector, higher OAS reflects the risk associated with possible overstatement of the housing turnover rate.
Clearly, these market phenomena defeat the very purpose of a constant OAS approach. Rich-cheap judgments become inconclusive, and rate shock analysis can produce inaccurate hedge ratios.1
Like Cheyette [1996] and Cohler, Feldman, and Lancaster [1997], we attribute the OAS and its variability to the prepayment risk premium, i.e., possible nondiversifiable deviations of actual future prepayments from a best guess prepay model's forecast.
It is the market's fear of systematic bias in prepayment forecasts that leads to a risk premium. If prepayments were perfectly predictable, then an exact, even inefficient, option exercise model should produce a zero OAS to an appropriate option-free benchmark, just as options and embedded option instruments with known algorithms of exercise such as swaptions, callable agency debt, and corporate bonds are all priced flat to their respective option-free rate curves.
While OAS varies widely among instruments, our new spread measure, called prepayment risk- and optionadjusted spread (prOAS, pronounced pro-A-S), accounts for both option and prepayment risk. We posit that, on a prOAS basis, all liquid agency MBS should be priced flat to agency debentures, eliminating the variability found in traditional OAS measures. Our method has its roots in the capital asset pricing model (CAPM) and its extension, arbitrage pricing theory (APT), where return compensation for risk and the concept of equivalent risk-neutrality play key roles.
For unstructured pass-throughs, we propose a prOAS valuation model that is armed with the power of backward induction and allows for endogenously finding risk measures and prices reflecting embedded prepay uncertainty-in the form of return spread compensation-computed for each investment period and...