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Dynamic Option Adjusted Spread and the Value of Mortgage Backed Securities

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  • Mario Cerrato
  • Abdelmadjid Djennad

Abstract

We extend a reduced form model for pricing pass-through mortgage backed securities (MBS) and provide a novel hedging tool for investors in this market. To calculate the price of an MBS, traders use what is known as option-adjusted spread (OAS). The resulting OAS value represents the required basis points adjustment to reference curve discounting rates needed to match an observed market price. The OAS suffers from some drawbacks. For example, it remains constant until the maturity of the bond (thirty years in mortgage-backed securities), and does not incorporate interest rate volatility. We suggest instead what we call dynamic option adjusted spread (DOAS). The latter allows investors in the mortgage market to account for both prepayments risk and changes of the yield curve.

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File URL: http://www.gla.ac.uk/media/media_117452_en.pdf
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Bibliographic Info

Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2009_16.

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Date of creation: Jan 2008
Date of revision: Apr 2009
Handle: RePEc:gla:glaewp:2009_16

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Related research

Keywords: Asset pricing; Mortgage Backed Securities; Term Structure Ambiguity; arrival rate of innovation; R&D investments.;

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  1. Heath, David & Jarrow, Robert & Morton, Andrew, 1992. "Bond Pricing and the Term Structure of Interest Rates: A New Methodology for Contingent Claims Valuation," Econometrica, Econometric Society, vol. 60(1), pages 77-105, January.
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