VALUATION OF CMOS
Jan 20, 2016
VALUATION OF CMOS
VALUATION OF CMOS
IntroductionSTATIC VALUATIONDYNAMIC VALUATION MODELINGOption-adjusted spread(OAS) Other products of the OAS modelsIllustration Plain vanilla structure A PAC/Supports structure A reverse pay structure
STATIC VALUATION
Average life
Static Spread refinancing rate fixed Zero volatility OAS
received principal Total
T at time Principal T1 at time Principal 1
DYNAMIC VALUATION MODELING
Option-adjusted spread(OAS)A measure of the yield spread that can be
used to reconcile dollar differences between value and price
using simulation to generate Monthly cash flows are path-dependent
SIMULATIONStep 1 : generating many scenarios of
future interest rate path
SIMULATIONStep 2 : generating refinancing rate
corresponding to the scenarios
SIMULATIONStep 3: generating cash flow
SIMULATIONStep 4 : generating spot rate
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SIMULATION
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INTERPRETATION OF OAS
Be used to reconcile value with market price
Be measuring the average spread over the Treasury spot rate cure, not the Treasury yield curve
An average spread
Option cost = Static spread – Option-adjusted
spread
OPTION-ADJUSTED DURATION
Measure the price sensitivity of a bond to a small change in interest rates.
Duration= P- - P+ / P0 (y+ -y-) Effective durationAssume: parallel shift in the yield curve
Increase in price Decrease in price
Positive convexity X% Less than X%
Negative convexity X% More than X%
OPTION-ADJUSTED CONVEXITY
•Convexity is the rate of change of the dollar duration of a security•When the prevailing mortgage rate is much higher than the mortgage rate ---Positive convexity •Effective convexity
Simulated Average Life
Is the average of the average lives along the interest rate paths
The greater the range and standard deviation of the average life, the more the uncertainty about the tranche’s average life
structure
Plain Vanilla Structure
Base case (assumes 12% interest rate volatility)C is better--- high OAS but low option cost
PrepaymentSlow--- OAS decrease, IO increase
VolatilityIncrease---longer tranches benefit more
PAC/Support Bond StructureStructure
Base case
prepayment
volatility
Reverse PAC Deal
structure
After support goes,can move prepayments down to last tranche, protect higher classes from contract risk
Average Life
OA-Duration
OA-Convexity
PAC C 10.9 6.3 -0.22
PAC D 19.7 5.9 0.04
THE END