Chapter 12 Lecture slides

# Chapter 12 Lecture slides - Chapter 12 Valuing...

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Chapter 12 Valuing Mortgage-Backed and Asset-Backed Securities David S. Krause, Marquette University

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Key Points of Chapter Valuing a fixed income security: 1. For an option-free bond, Z-spread is appropriate. 2. For a bond with an embedded option, OAS is appropriate. Binomial model (backward induction method) is used. 3. For bonds with embedded options (where interest rate risk is path dependent), OAS is appropriate with a cash flow, Monte Carlo interest simulation model.
Cash Flow (Z spread) Yield Analysis The yield on any financial instrument is the interest rate that makes the present value of the expected cash flow equal to its market price plus accrued interest. When applied to mortgage-backed and asset-backed securities, this yield is called a cash flow yield. The cash flow yield is the interest rate that makes the present value of the projected cash flow for a mortgage-backed or asset-backed security equal to its market price plus accrued interest.

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Limitations of Cash Flow Yield Measure All yield measures suffer from problems that limit their use in assessing a security’s potential return. The yield to maturity has two major shortcomings as a measure of a bond’s potential return. To realize the stated yield to maturity, the investor must: 1. reinvest the coupon payments at a rate equal to the yield to maturity, and 2. hold the bond to the maturity date
OAS Yield Spread Measure For MBS and ABS we need a yield spread measure that indicates the potential compensation after adjusting for prepayment risk. This measure is called the option- adjusted spread (OAS). This method was introduced in Chapter 9 where the valuation of corporate and agency bonds with embedded options was presented. If the structured product has an option and the borrower tends to take advantage of that option when interest rates decline, then the OAS should be used.

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Monte Carlo Simulation Model and OAS It was previously discussed that a binomial model can be used to value callable agency and corporate bonds. This approach accommodated securities in which the decision to
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## This note was uploaded on 03/19/2011 for the course ACCT 440 taught by Professor Smith during the Spring '11 term at Saginaw Valley.

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Chapter 12 Lecture slides - Chapter 12 Valuing...

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