FBE559.slides.10

Example say we agree that 1 there is a 2 chance that

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Unformatted text preview: is a 2% chance that the first play of the Superbowl is a safety. 2 There is a 2% chance that housing prices in LA county fall by 20% in the next year. Would you prefer to have a security that pays $1 in the first case or the second one? CDO’s pool mortgages and go from a not so bad outcome (one particular homeowner defaults) to one which concentrates bad states together. Pricing If we have a security that pays $100 if no default, and $0 if default, how do we maximize the yield if we want to fix the default probability? Equivalently, how to minimize the price: 100(1 − q ) E q [payoff] = 1+r 1+r where q is the risk-neutral probability of default. p= We need: Make the q probability as big as possible Subject to the actual probability of default being say 1% To do this, make default as bad an event as possible What will the losses be? Lehman Brothers | ABS Strategies Weekly Outlook F i ve P o t e n t i a l H P A S c e n a r i o s We perform a scenario analysis of projected HEL performance ... Estimating the future trajectory of the housing market is the most critical as well as most challenging aspect of forecasting mortgage credit. Projecting future home price growth involves numerous factors such as migration trends, job market growth, mortgage product innovation, interest rates etc. Therefore, we believe it is more useful to perform a scenario analysis of expected HEL performance across a range of housing market scenarios, without getting into a discussion about the most likely scenario. … across five potential housing market scenarios. We construct five potential...
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