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Dynamic Option Adjusted Spread and the Value of Mortgage Backed Securities

Author

Listed:
  • 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.

Suggested Citation

  • Mario Cerrato & Abdelmadjid Djennad, 2008. "Dynamic Option Adjusted Spread and the Value of Mortgage Backed Securities," Working Papers 2009_16, Business School - Economics, University of Glasgow, revised Apr 2009.
    • Handle: RePEc:gla:glaewp:2009_16
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    References listed on IDEAS

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    1. David Heath & Robert Jarrow & Andrew Morton, 2008. "Bond Pricing And The Term Structure Of Interest Rates: A New Methodology For Contingent Claims Valuation," World Scientific Book Chapters, in: Financial Derivatives Pricing Selected Works of Robert Jarrow, chapter 13, pages 277-305, World Scientific Publishing Co. Pte. Ltd..
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    More about this item

    Keywords

    Asset pricing; Mortgage Backed Securities; Term Structure Ambiguity; arrival rate of innovation; R&D investments.;
    All these keywords.

    JEL classification:

    • C23 - Mathematical and Quantitative Methods - - Single Equation Models; Single Variables - - - Models with Panel Data; Spatio-temporal Models
    • G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance

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