Prepayment Risk- and Option-Adjusted Valuation of MBS opportunities for arbitrai^e

SUMMKR 2005 O ption-adjusted spread (OAS), while a much better measure than yield or static spread, still tails short in explaining the dynamics of mortgage pricing. The standard OAS typically varies across instruments {pass-throughs, collateralized mortgage obligations, interest-only securities, principal-only securities), coupons, prepayment option moneyness, and pool seasoning stages. Premium and discount MBS are often priced at wider OAS than the current-coupon issues. Premium MBS and lOs stripped oft premium pools are considered hazardous, and their higher OAS reflect concerns of understated refinancing. Naturally, the respective POs look rich. In the discount sector, higher OAS reflects the risk associated with possible overstatement of the housing turnover rate. Clearly, these market phenomena defeat the very purpose ofa constant OAS approach. Rich-cheap judgments become inconclusive, and rate shock analysis can produce inaccurate hedge ratios.' Like Cheyette [1996] and Cohler, Feldman, and Lancaster [1997], we attribute the OAS and its variability to the prepayment risk premium, i.e., possible nondiversifiable deviations of actual future prepayments fix)m a best guess prepay model's forecast. It is the market's fear of systematic bias in prepayment forecasts that leads to a risk premium. If prepayments were perfectly predictable, then an exact, even inefficient, option exercise model should produce a zero OAS to an appropriate option-trf e benchmark, just as options and