VALUATION OF CMOS. Introduction STATIC VALUATION DYNAMIC VALUATION MODELING Option-adjusted...
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Transcript of VALUATION OF CMOS. Introduction STATIC VALUATION DYNAMIC VALUATION MODELING Option-adjusted...
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VALUATION OF CMOS
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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
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STATIC VALUATION
Average life
Static Spread refinancing rate fixed Zero volatility OAS
received principal Total
T at time Principal T1 at time Principal 1
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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
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SIMULATIONStep 1 : generating many scenarios of
future interest rate path
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SIMULATIONStep 2 : generating refinancing rate
corresponding to the scenarios
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SIMULATIONStep 3: generating cash flow
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SIMULATIONStep 4 : generating spot rate
1 11 1 nZ /121T T
T nfnfnf
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SIMULATION
T
T
TT
KnZ1
nCnCPV
N
NPath PV 2Path PV 1Path PV PriceMarket
nC PVnC PVnC PV nPath PV 36021
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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
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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
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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
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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
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structure
Plain Vanilla Structure
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Base case (assumes 12% interest rate volatility)C is better--- high OAS but low option cost
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PrepaymentSlow--- OAS decrease, IO increase
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VolatilityIncrease---longer tranches benefit more
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PAC/Support Bond StructureStructure
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Base case
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prepayment
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volatility
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Reverse PAC Deal
structure
After support goes,can move prepayments down to last tranche, protect higher classes from contract risk
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Average Life
OA-Duration
OA-Convexity
PAC C 10.9 6.3 -0.22
PAC D 19.7 5.9 0.04
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THE END