Valuation of Mortgage-Backed Securities

Rajashri (Priya) Joshi, Tom Davis and Bill McCoy

in The Handbook of Mortgage-Backed Securities

Published in print August 2016 | ISBN: 9780198785774
Published online October 2016 | e-ISBN: 9780191827594 | DOI:
Valuation of Mortgage-Backed Securities

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This chapter describes and illustrates the elements and mechanics of valuing mortgage-backed securities (MBS). It begins with the basics of valuation and then briefly reviews the sources of MBS prepayments. Next, it discusses the models and assumptions that go into generating a set of projected cash flows. Forecasting MBS prepayment speeds and, in turn, total cash flows, is a much more complex undertaking than predicting the timing of redemption of a callable corporate bond. Practitioners generally rely on econometric prepayment models and associated auxiliary models to generate speed and cash flow forecasts, which are then used to value the bond. The Monte Carlo simulation is the only viable methodology for valuing mortgage-backed securities, as closed-form solutions are unavailable, and the path-dependent nature of the embedded prepayment option generally precludes the use of lattice-based approaches.

Keywords: valuing mortgage-backed securities; MBS; valuation; MBS prepayments; total cash flow; timing of redemption; callable corporate bond; econometric prepayment models; Monte Carlo simulation

Chapter.  11353 words.  Illustrated.

Subjects: Financial Markets ; Macroeconomics and Monetary Economics

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