CFA Level 2 - Fixed Income


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Default/Credit Spread/Downgrade Risk 1. Default risk is the risk that the borrower will not repay the obligation. 2. Credit spread risk is the risk that the credit spread will increase and cause the value of the issue to decrease and/or cause the bond to underperform its benchmark. 3. Downgrade risk is the risk that the issue will be downgraded by the credit rating agencies, whcih will also cause the bond price to fall, and/or cause the bond to underperform its benchmark.
Four C's of Credit Analysis 1. Character - mgmt integrity + commitment to repay. 2. Covenants : affirmative - require the debtor to take action, negative - restrict actions. 3. Collateral - least useful for credit analysis = assets offered as a pledge for repayment. 4. Capacity to pay - borrowers ability to generate cash flow or liquidate Short Term assets to repay debt. (Moody's considers: 1. industry trends, 2, regulatory environment, 3. operating and competitive environment, 4. financial position and sources of liquidity.).
Profitability Ratios Assess the issuer's ability to generate earnings sufficient to pay interest and repay principal. ROE = NI/Equity = NI/Sales X Sales/Total Assets X Total Assets/Stockholders equity
Short Term Solvency Ratios Measure of the firm's ability to repay its short-term debt obligations by liquidating short term assets. Current ratio. Acid Test Ratio = Current A - Inventory / Current L
Capitalization (Financial Leverage) Ratios Evaluated w/ reference to the industry in order to determine the firm's ability to take on the additional risk associated with increased borrowing. Long-Term Debt to Cap = Long Term Debt / (LT Debt + Minority Interest + SE) Compares w/ ratios> industry avg. have less capacity to take on more long term debt.
Coverage Ratios Measure the firm's ability to repay its debt + lease obligations out of operating CF. EBIT Coverage Ratio = EBIT/ Annual Interest Expense. EBITDA Coverage Ratio = EBITDA/ Annual interest expense. Variability of these ratios is an important consideration to a bondholder.
2/28 Adjustable Subprime Mortgages Mortgage where the borrower is not required to put any $ down. The mortgage has a two year teaser rate, that subsequently adjusts upward by approx. 5% after 2 yrs. Full interset pmts were optional, which meant that negative amortization was available @ the option of the borrower.
Minsky Framework A stable economy progresses in three steps towards instability. 1. Hedge unit - investment is backed by sufficient income generating capability to pay back both principal + interest on its debt financing (30 year fixed mortgages) 2. Speculative Unit - investment has enough CF to pay interest, but not principal. Borrower is speculating stable interest rates and property values. 3. Ponzi Unit - CF cannot cover interest or principal. Negaive amortization occurs. THe borrower is speculating rising property values. The longer the economy has been stable, the more likely it is to shift towards instability.
Yield Curve Twist Chg. in the yield curve when the slope becomes either flatter (narrower spreads) or steeper.
Butterfly Shift Chng. in the degree of curvature. Positive butterfly means that the yield curve becomes less curved. Negative butterfly = more curve.
All on-the-run securities to construct theoretical spot rate curve On-the-run issues have the largest trading volume, and therefore are the most accurately priced issues. However, due to tax effects on premium and discount priced issues, it is not appropriate to use observed yields unless they are trading @ par. A: uses most accurately priced issues. D: Significant maturity gaps after 5-yrs.
All on-the-run securities and some off-the run to construct theoretical spot rate curve Allows for lower maturity gaps by using issues from both sources. A: Reduces maturity gaps. D: 1. Still doesnt use all rate info contained in treasury mkt. 2. rates me distorted if off the run issues are cheap in the repo mkt.
All Treasury securities to construct theoretical spot rate curve A: Uses all information available in mkt. D: 1. Some maturities may have more than one yield. 2. Current prices may not reflect accurate interest rates for all maturities.
Treasury STRIPS to estimate curve A: 1. Provides yields @ most maturities. 2. Intuitive approach that does not require bootstrapping. D: 1. liquidity premium is embedded in STRIP yields as strips are not as liquid as treasuries. 2. Tax treatment affects observed rates.
Swap Rate (LIBOR) Curve Series of swap rates from 2 to 30 years that specifies rates at which one party pays fixed swap rate. Preference of swap rate curve over gov't bond curve b/c: 1. Swap mkt is not regulated by any gov't, which means swap rates in different countries are comparable. 2. Supply of swaps and equilibrium pricing depends only on # of participants in the mkt. 3. Swap curves across countries are comparable b/c they reflect similar levels of credit risk (no soverign risk). 4. Swap curves quotes a larger # of maturities than the US Treasury curve.
Pure Expectations Theory Suggests that forward rates are solely a function of expected future spot rates. 1. if curve is upward sloping, ST rates are expected to rise. However, it fails to consider price and reinvestment risk. The risk of investing in a 5 yr bond is different than investing in a 2 yr then a 3 yr.
Liquidity Theory Forward rates reflect investors expectations of future spot rates plus a liquidity premium that is positively related to maturity. Postive slope can therefore mean: 1. mkt expects future rates to rise, 2. rates are expected to remain constant but a liquidity premium causes the positive slope.
Premium Over Straight Value = Downside risk of convertible. = Mkt price of convertible bond / straight value - 1
Preferred Habitat Theory Forward rates represent expected future spot rates plus a premium not necessarily related to maturity. The existence of imbalance between Supply and demand @ certain maturities will cause investors to shift from their preferred habitiats. However, to do so borrowers require cost savings (decreased yields) and lenders require a yield premium. 1. Risk premium is positive or negative and is related to S+ D for funds @ various maturities, not a liquidity premium. 2. Risk premium is not necessarily related to maturity.
Key Rate Duration Approx %chng in response to a 1% chng. in the corresponding key rate, holding all other rates constant. Every security or portfolio has a set of key rate durations, one for each key rate. This allows us to measure the impact of non parallel shifts on a portfolio. The effective duration of a portfolio = wgtd avg. of the key rate durations of its individual security durations, where the weights are based on the mkt vale portfolio weights.
Yield Volatility Using historical data, yield volatility is measured by the std. dev. of daily yield chngs. Continuously compounded changes = ln(ratio of yield levels). Variance = Sum(Xt-X_)^2 / T-1, where Xt= 100 x ln(yt/yt-1)
Interpreting Historical Yield Volatility If Std. Dev. = 10%, and Yield = 8%, the std. deviation = 80 bps (8% x .10) The std. deviation of yield chngs in bps is then used to construct confidence intervals. This can determine the probability of yield chngs. w/in a certain number of std. deviations.
Implied Yield Volatility = Yield volatility derived from option prices. Criticized b/c: 1. assumes option pricing model is correct. 2. makes simplifying assumption that volatility is constant.
Nominal Spread = Bonds YTM - yield on a comparable maturity Treasury benchmark security. The problem w/ nominal spread is that it uses a single interest rate to discount each CF that makes up the bond. If the yield curve is not flat, each CF should be discounted @ the appropriate spot rate for that maturity.
Z- Spread = Spread that when added to each spot rate on the yield curve, makes the PV of the bond's CFs = bond's mkt price. Assumes that interest rate volatility = 0. If interest rates are volatile, Z Spread is not appropriate to value bonds w/ embedded pitons, because the Z spread includes the cost of the option. Nominal approx. = Z spread, but the difference becomes larger when: 1. Yield curve is not flat. 2. for securities that repay principal over time. 3. for securities w/ longer maturities.
OAS The spread on a bond w/ an embedded option, after the embedded option cost has been removed. = Z spread - option cost.
Valuing a callable bond w/ an interest rate Tree Value used @ any node corresponding to the call date and beyond must be either the price @ which the issuer will call the bond @ that date, or the value of the bond if not called. Whichever is less.
OAS = Interest rate that must be added to all of the one year forward rates in a binomial tree, so that the theoretical value of a callable bond generated w/in the tree = mkt. price. Z Spread = OAS for option free bonds.
Relative Value Analysis Involves comparing the spread on the bond, over some benchmark, to the required spread and determining whether the bond is over or under valued. Overvalued "rich" bonds = spread < required spread. Undervalued "cheap" bonds = spread > required spread.
Modified Duration Measures a bond's sensitivity to interest rate changes, assuming that the bonds CFs do not change as interest rates change. The std. measure of convexity can be used to improve price changes estimated from modified duration. Not useful for bonds w/ embedded options b/c CFs from these bonds will change if option is exercised.
Effective Duration Should be used for valuing callable bonds b/c these measures take into account how changes in interst rates may alter cfs.
Convertible Bond The owner of a convertible bond has the right to convert the bond into a fixed # of common shares of the issuer. Hence, a convertible bond owner holds an embedded call option. Option is slightly different than callable bond b/c: 1. Bond owner not issuer holds call option. 2. Holder has right to buy shares w/ a bond that changes in value, not with cash @ fixed exercise price.
Conversion Ratio # of common shares for which a convertible bond can be exchanged. Conversion price = issue price/conversion ratio
Conversion Value = Mkt price of stock X conversion ratio. Straight value = value of bond if it were not convertible = PV of bonds CFs discounted @ rate on a comparable option free issue. Minimum value = greater of its conversion value or its straight value. This must be the case or arbitrage opportunities would be available.
Mkt Conversion Price = Price that the convertible bondholder would effective pay for the stock if they bought the bond and immediately converted it. = mkt price of convertible bond / conversion ratio. Mkt conversion premium/share = difference between the mkt conversion price and the stocks current market price.
Mkt Conversion Premium Ratio = Mkt Conversion Premium/share / Mkt price of common stock
Premium Payback Period The time it takes to recoup the difference between the coupon income and the dividend income as coupon > div. = Mkt conversion premium per share / favorable income difference per share. Favorable income difference/share = [Coupon interest -(conversion ratio x divs/share)] / conversion ratio
Volatility and Convertible Bond Prices B/C convertible bond = option free bond + call option in amt = conversion ratio, volatility directly impacts convertible bond values. Increased stock price volatility increases value of call on stock, and increases convertible value. Increased interest rate volitility increases the value of the call on the bond and reduces the value of a callable convertible bond.
Owning Convertible Bonds vs. Stock Outright Buying convertibles in lieu of stocks limits downside risk, due to price floor set by the Straight Value. However, the cost of this protection comes at the reduced upside potential due to the conversion premium.
Fixed Rate, Level Pmt, Fully Amortized Mortgage Loans 4 Key Features: 1. The amount of principal pmt increases as time passes. 2. The amount of interest decreases as time passes. 3. The servicing fee also declines as time passes. 4. The ability of the borrower to repay results in prepayment risk.
Servicing Fee Fee that covers the expense associated with collecting pmts and all the other admin. activities. This is usually built into the mortgage rate. ie. If rate = 10.5% and servicing fee = 35bps, the provider of mortgage funds will receive 10.15%
Prepayment/Curtailment Prepayment = pmt in excess of required monthly amount. Curtailment = prepayment for less than the total outstanding principal balance.
Mortgage Passthrough Security Represents a claim against a pool of mortgages. The mortgages in the pool have different maturities and different rates. Wgtd. Avg. Maturity (WAM) = wtd. avg of all the mortgages in the pool by relative outstanding mortgage balance to the value of the entire pool. Wgt. Avg. Coupon (WAC) = wtd avg of the mortgage rates in the pool.
Conditional Prepayment Rate (CPR) Annual rate @ which a mortgage pool balance is assumed to be prepaid during the life of the pool. CPR is a function of past prepayment rates and expected future economic conditions.
Single Monthly Mortality Rate (SMM) = 1 - (1-CPR)^1/12 This is the conversion of a CPR into a monthly rate. A SMM of 10% implies that 10% of a pools beginning of month outstanding balance, less scheduled payments, will be repaid during the month.
PSA Prepayment Benchmark Expressed as a monthly series of CPRs. The PSA benchmark assumes that the monthly prepayment rate for a mortgage pool increases as it ages. 1. PSA Std. Benchmark = 100 PSA. 100 PSA assumes the following graduated CPRs for mortgages: 1. CPR = 0.2% for the 1st month, increasing by 0.2%/month for up to 30 months. CPR=6% for months 30-360.
Estimating Prepayment Given SMM Prepayment = SMM X (Mortgage balance @ beginning of month -scheduled principal payment for month m)
Three Main Factors that Affect Prepayments 1. Prevailing mortgage rates, by influencing: a. spread between current rate and original mortgage rate. b. Path of mortgage rates (refinancing burnout). 2. Housing turnover increases as rates fall and housing becomes more affordable. Also, higher during economic growth. 3. Characteristics fo underlying mortgage: a. seasoning, prepayments increase as loans age. b. local economies, prepayments are faster in some geographic areas than others.
Contraction Risk Prepayment Risk Type, refers to the shortening of the expected life of the mortgage pool due to falling interest rates and higher prepayment rates. 1. MBS exhibit negative convexity as rates decline due to embedded call option of right to repay, hence, upside potential of holding passthroughs is restricted. 2. Reinvestment rate risk occurs b/c refinancing occurs during declining interest rates and therefore investors must reinvest @ less desireable leveles.
Extension Risk Associated w/ interest rate increases + falling prepayment rates. Bond prices fall when rates increase w/ passthroughs this decrease compounds the price decline b/c the timing of the passthrough CFs is extended. This is undesireable b/c when rates rise, investors would like to reinvest principal @ higher rates.
Sequential Pay CMO A CMO in which each class of bonds is retired sequentially. Contraction and extension risk are distrubted amongst the tranches.
Principal Pay Down Window Time period between when the first and last principal pmts occur on a CMO tranche.
Z-Tranche/Accrual Tranche CMO Tranche that is the last tranche to be paid and also does not receive current interest until all other tranches have been fully paid off. Interst that would be paid to the Z-tranch pays principal for other tranches first. THe diverted interest accruse and is added to the outstanding Z tranche principal balance.
Planned Amortization Class (PAC) Most common type of CMO. Tranche is amortized based on a sinking fund schedule that is established w/in a range of prepayment speeds called the initial PAC collar. There are two prepayment schedules for a PAC bond. One with a lower prepayment rate and one for the upper prepayment rate. PAC bondholders are guaranteed a principal pmt that is equal to the lessare amount perscribed by the two prepayment speeds.
Support Tranche Necessary for a PAC bond to work. The support tranche provides prepayment protection for the PAC. The support tranche will absorb excess prepayments, such that pmts to the PAC are constant given that prepayment speeds are w/in a specified range. If prepayment speeds are outside the collar, the PAC schedule may not necessarily be met. The certainty of PAC CFs comes @ the expense of increased risk to the support tranches.
Principal Only Strips (PO) Class of securities that receive only the principal pmt portion of each mortgage pmt. They are sold @ discount to par. PO CF stream starts out small + increases w/ the passage of time. The entire par value of a PO is evenutally pd to the investor, the only question is whether realzied prepayment rates will cause it to be paid sooner than expected.
Interest Only (IO) Strips Class that receives only the interest portion of each payment. CF starts big + gets smaller over time. Thus, they have shorter effective lives than PO. The major risk is that the value of the CF the investor receives may be less than intially expeceted, and possibly less than originally invested due to prepayment speed.
Commercial MBS (CMBS) MBS backed by income producing real estate. The loans are typically originiated by conduit organizations. Biggest difference between MBS and CMBS is the obligation of the underlying borrower. CMBS loans are nonrecourse loans, meaning that the lender can only look to the collarteral as mean of repayment for a delinquent loan. Therefore CMBS analysis focuses on the credit risk of the property, not the borrower.
Debt to Service Coverage Ratio = NOI / Debt Service . CF coverage ratio of the amount of the CF from a commercial property available to make debt service payments. NOI is calculated after the deduction of real estate taxes, but before any relevante income taxes. The higher the better for this ratio from the perspective of the MBS investor.
Loan-to-Value Ratio Compares the loan amount on the property to its current fair market or appraisal value. = Current Mortgage Amount / Current Appraised Value. Lower is better from perspective of CMBS investor. Determines amount of collateral above the loan amount to provide a cushion to the lender, should the property be foreclosed on and sold.
Loan Level Call Protection 1. Prepayment Lockout - restricts prepmts for a certain period of time. 2. Defesance - loan servicer invests prepayments in Treasury securities rather than passing the CFs to the investor. This increases the credit quality of the pool b/c Treasuries are higher rated than mortgages. 3. Prepayment Penalty Points - fee charged if borrower prepays. 4. Yield Maintenance Charges - borrower is charged the amount of the interest lost by the lender, should the loan be prepaid.
CMBS Level Call Protection CMBS loan pools are segregated into senior and junior tranches. Traches w/ a higher priority for prepayment or collateral position will have a higher gredit rating thanthe loewr tranches b/c loan defaults will first affect lower tranches.
Parties to ABS Transactions 1. Seller - originates the loans and sells the portfolio of loans to the trust (SPV). 2. Issuer/Trust - SPV that buys the loans from the seller and issues ABS to investors. 3. Servicer - services the loans.
Prepayment/Time Tranching ABS structure that distributes prepayment risk among different tranches.
Credit Tranching Senior/Subordinated Structure in which subordinated bonds first absorb all looses up to their par value, after which any additional losses are absorbed by the senior bonds. Credit risk is shifted from senior to subordinated tranchse.
Amortizing Assets Loans for which the borrower makes periodic scheduled prepayments that include both principal and interest. The interest amount is subtracted from the total payment, and the balance is applied toward the principal, reducing the outstanding loan.
Non-Amortizing Assets Loans that do not have a scheduled payment amount. Instead, a minimum payment, which is applied against accrued interest is required. If pmt> accrued interest, the excess is applied towards reducing outstanding principal.
Revolving Structure Used for ABS comprised of non-amortizing loans, where pool of loans is not fixed. There is usually a lockout period where principal pmts and prepayments are not distributed to the bondholders, but rather are reinvested in new loans.
External Credit Enhancement Financial guarantees from 3rd parties that support the performance of the bond. 1. Corporate Guarantees - sponsor guarantees a portion of the offer. 2. Letter of credit - bank guarantees loss up to a certain level. 3. Bond insurance - insurance against non performance. The problem w/ external credit enhancement is the "weak link" philosophy adopted by rating agencies. The credit rating of an issue cannot exceed the rating of the third party.
Internal Credit Enhancement 1. Reserve Funds: a. cash reserve funds - cash deposits that come from issuance proceeds. b. excess servicing spread funds - excess spread or cash after payinf for servicing and other expenses. 2. Overcollateralization - ABS issued w/ a face value < value of underlying collateral. 3. Senior/Subordinated Structure.
Shifting Interest Mechanism Addresses the changes in the level of credit protection provided by junior tranches as prepayments occur in a senior/subordinated structure. This reduces the credit risk of the senior tranche @ expense of increased prepayment risk. Prepayments are allocated partially to senior tranches in the early years, so as to not exhaust junior tranches. This ensures that credit protection is still provided by junior tranches, however prepayment risk in senior tranches increases due to tradeoff.
Home Equity Loan Loans bakced by residential property. Typically lower credit qualitiy borrowers, so prepayments are less common than w/ MBS. Projected prepmts are outlined in the Prospectus Prepayment Curve (PPC). They are organized in tranches: Non-Accelerating Senior Tranches (NAS) - receives pmts pbased on a predetermined schedule. The % of prepmts allocated to NAS is small in early years and larger as time passes. PAC Tranche - similar to MBS.
Manufactured Housing Backed Security Fully amortizing loans, simlar to mortgage. Lower prepayments due to: smaller loan balances, depreciation of home> reduction of principal in early months, borrowers likely to have low credit ratings which makes refinancing difficult.
Auto Loan ABS Prepay if cars are sold, traded, etc. Refinancing is not a major factor for car prepmts b/c loan values are relatively small, and depreciation outpaces principal reduction in the ealry months. Absolute Prepayment Speed (ABS) = monthly prepayment as a % of value of initla collateral. Similar to CPR. SMM = ABS/ [1-(ABS x(m-1))] Where: m = months since loan origination.
Credit Card Receivable Backed Securities ABS backed by pool of receivables when principal is not amortized. B/c of this, there is a lockout period where principal repayments are used to purchase additional loans, rather than be paid to investors. The disribution of pmts usually follows one of 3 schedules. 1. Passthrough structure where principal is distributed pro rata. 2. Controlloed amortization structure, similar to PAC with low principal pmts. 3. Bullet Pmt Structure : one lump sum.
Net Portfolio Yield Used to asses performance of receivables portfolio. = Gross Portfolio Yield - Charge Offs. - If wgtd avg coupon promised to ABS Tranches > net portfolio yield, there is risk that the tranches will not be paid off as promised.
Delinquencies = % of past due receivables. High delinquincies signal potential future charge offs and lower net portfolio yield.
Monthly Prepayment Rate = Monthly pmts as % of outstanding receivables @ previous months end. Low MPR signals : - increased extension risk of ABS tranches. - Insufficient CF to pay off tranches.
CDO ABS that is collateralized by a pool of debt obligations. Characterized by: - one or more senior tranches. - several mezzanine tranches. - subordinate tranche (equity tranche) to provide protection from prepayment and credit events for other tranches. The senior tranche (70-80% of the pool) is assigned a floating rate pmt, while mezzanine tranches are fixed rate. B/c the pool is comprised of fixed and floating, but pmts are primarily floating, asset managers use interest rate swaps.
Cash Flow CDO Objective for PM is to generate sufficient CF to repay senior and mezzanine tranches. 3 phases: 1. Ramp Up- PM puts together a portfolio through sale of various tranches. 2. Reinvestment phase, portfolio has been established and PM monitors portfolio and reinvests prepayments. 3. Pay Down Phase - 3-5 yrs. principal pmts are made to junior and senior tranches. Equity tranche only gets pd if certain coverage tests are met.
Market Value CDO -Mgr actively manages the portfolio and sells assets to generate CF to meet the CDO obligation. The PM of a mkt value CDO has more flexibility than the pm of a CF CDO.
Synthetic CDO - Bondholders take on economic risks of the underlying assets but do not take legal ownership of them . This is accomplished by linking contingent pmts to a reference asset. The CDO is divided into senior and junior tranches. Debt is issued to fund junior section, but not senior. THe CDO is issued for a notional amount, of which only a small portion is funded. The note holders then sell a CDS = notional - funded amt.
Why Synthetic rather than Cash CDO? 1. Senior sector of synthetic doesnt require funding. 2. Ramp - up period is shorter. 3. it is cheaper to buy exposure to an asset through a CDS rather than buying the asset directly.
Motivations for creating CDOs 1. Arbitrage Driven - motiviation is to generate an arbitrage return on the spread between the return on the collateral and the funding costs. 2. Balance sheet driven - motivation is to remove assets from the bs.
Cash Flow Yield = discount rate that makes the market price of a MBS or ABS equal to the PV fo CFs. Bond Equivalent Yield = 2[(1+monthly CFY)^6 - 1] The challenge is that CFs from ABS are uncertain, and therefore we must make a prepayment assumption.
Major Deficiencies of CFY Assumes that: 1. CFs will be reinvested @ CFY prevailing when the MBS is issued. (Reinvestment Risk) 2. The MBS will be held until maturity. If security is sold prior to maturity, uncertainty is introduced regarding terminal CF (price risk). 3. The CFs will be realized as expected (prepayment risk)
Nominal Spread = CFY on MBS - YTM on a Treasury security w/ similar maturity. The limitation of using the nominal spread to analyze a MBS is that we don't know how much of the nominal spread reflects the significant prepayment risk associated w/ MBS.
Zero Volatility Spread - spread that must be added to each Treasury spot rate that will cause the discounted value of the CFs for a MBS to equal its price assuming the security is held to maturity. The key limitation of the Z Spread is that it only consideres one path of interest rates, the current Treasury spot curve. (OAS is better for bonds w/ embedded options b/c it considers every path along the interest rate tree.)
Path Dependency Due to path dependence of MBS CFs, the Monte Carlo Simulation technique is used to value these securities, instead of the binomial model. Two sources of path dependency: 1. If rates trend downward over a period of time, prepayment rates will increase @ the beginning of the trend as homeowners refinance their mortages, but it will slow due to prepayment burnout. 2. THe CFs that a particular CMO tranche receives in any one month depend on the principal balances of the other tranches in the structure, which in turn depend on the prepayment history and interest rate path.
OAS OAS = MBS spread after the "optionality" of the CFs is taken into account. We can use the relationship between OAS and Z-spread to estimate the cost of the embedded prepayment option inherent in the MBS. In general, you want the OAS to be large. Larger OAS indicates larger risk-adjusted spread = lower price. OAS for MBS = additional compensation, for credit, liquidity, and modelling risk after the cost of the embedded prepayment option has been removed.
Modelling Risk The uncertainty in the MBS value that results from the use of assumptions in the Monte Carlo Framework. The interest rate assumption and prepayment assumption, for example.
OAS Analysis For a given Z spread and Duration: 1. Cheap securities will have high OAS relative to the required OAS, and low option costs. 2. Rich securities will have low OAS relative to the required OAS and high option costs. Cheap securities are undervalued and we should buy them.
Effective Duration and why estimates may differ among providers 1. If chng. Y is too large, the effects of convexity contaminate the effective duration estimates. 2. Prepayment models vary among dealers. 3. Differences in inputs into monte carlo simulation will affect OAS. 4. The assumed spread between 1- month rates and refinancing rates affects the computed values of the MBS. The different assumptions about this relationship will cause different BV for chng Y + and chng. Y -.
Cash Flow Duration Version of ED that allows for CFs to change as interest rates change. Based on a static valuation procedure to deterimine BV+chngY and BV-chngY, w/ a fixed prepayment assumption. CF duration for MBS is not as accurate as monte carlo duration b/c CF duration assumes the new MBS prepayment rate is constant over its entire life for a given shock to interest rates.
When to use Nominal Spread? Nominal Spread = CFY - YTM on Treasury w/ similar maturity. We should never use the nominal spread for MBS or ABS becuase it masks the fact that a portion of the spread is compensation for accepting prepayment risk.
When to use Z - Spread? = spread over entire Treasury spot curve if MBS is held until maturity. Shoudl not be used for bonds that have prepayment options b/c it does not reflect the possibliity that CFs might change as interest rates change. should be used to value ABS with no prepayment options, such as credit card or auto loan ABS.
When to use OAS? Should be used to assess value of securities that have embedded options that make it possible for CFs to change as interest rates change. 1. If CFs are not path dependent, binomial model should be used to calculate OAS. 2. IF CFs are path dependent (ABS, MBS), monte carlo simulation should be used.