IDEAS home Printed from https://ideas.repec.org/p/nbr/nberwo/2340.html
   My bibliography  Save this paper

Interest-Only/Principal-Only Mortgage-Backed Strips: A Valuation and Risk Analysis

Author

Listed:
  • Alan J. Marcus
  • Arnold Kling

Abstract

We examine the risk characteristics of each portion of IO/PO mortgage strips, present results of a valuation model of these securities, and examine market prices of both the interest-only and principal-only portions of mortgage pools. We show that IO/PO securities are highly sensitive to the prepayment behavior of the underlying mortgage pool. Because that behavior varies systematically with the interest rate, and because prepayments affect the values of I0 and PO components in opposite ways, the interest-rate risk of strip securities can differ substantially from that of the underlying mortgage pool. The PO component has much longer duration than the underlying mortgage pool. In contrast, the IO component typically will have a negative duration, at least in ranges for which interest-rate movements induce meaningful changes in mortgage prepayment behavior. We also show how market prices of partially-stripped MBSs that are actively traded on secondary markets can be used to infer market values of pure IO/PO strips. Recent market data is fully consistent with the theoretical insights offered by our valuation model. When interest rates spiked last April, PO values fell far more dramatically than those of the underlying mortgage pool while IO values actually rose.

Suggested Citation

  • Alan J. Marcus & Arnold Kling, 1987. "Interest-Only/Principal-Only Mortgage-Backed Strips: A Valuation and Risk Analysis," NBER Working Papers 2340, National Bureau of Economic Research, Inc.
    • Handle: RePEc:nbr:nberwo:2340
    Note: ME
    as

    Download full text from publisher

    File URL: http://www.nber.org/papers/w2340.pdf
    Download Restriction: no
    ---><---

    References listed on IDEAS

    as
    1. Dunn, Kenneth B & McConnell, John J, 1981. "A Comparison of Alternative Models for Pricing GNMA Mortgage-Backed Securities," Journal of Finance, American Finance Association, vol. 36(2), pages 471-484, May.
    2. Brennan, Michael J. & Schwartz, Eduardo S., 1977. "Savings bonds, retractable bonds and callable bonds," Journal of Financial Economics, Elsevier, vol. 5(1), pages 67-88, August.
    Full references (including those not matched with items on IDEAS)

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Patric H. Hendershott, 1986. "Mortgage Pricing: What Have We Learned So Far?," NBER Working Papers 1959, National Bureau of Economic Research, Inc.
    2. João Nunes, 2011. "American options and callable bonds under stochastic interest rates and endogenous bankruptcy," Review of Derivatives Research, Springer, vol. 14(3), pages 283-332, October.
    3. Wilson, Linus & Wu, Yan Wendy, 2012. "Escaping TARP," Journal of Financial Stability, Elsevier, vol. 8(1), pages 32-42.
    4. Y. D'Halluin & P. A. Forsyth & K. R. Vetzal & G. Labahn, 2001. "A numerical PDE approach for pricing callable bonds," Applied Mathematical Finance, Taylor & Francis Journals, vol. 8(1), pages 49-77.
    5. Samih Azar, 2015. "Why Callable Bonds Are not Called When the Market Price Reaches the Call Price: A Duration Argument," International Journal of Business and Management, Canadian Center of Science and Education, vol. 11(1), pages 1-90, December.
    6. Raymond C. Chiang & M. P. Narayanan, 1991. "Bond Refunding In Efficient Markets: A Dynamic Analysis With Tax Effects," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 14(4), pages 287-302, December.
    7. Spiros H. Martzoukos & Theodore M. Barnhill Jr., 1998. "The Survival Zone For A Bond With Both Call And Put Options Embedded," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 21(4), pages 419-430, December.
    8. Francis A. Longstaff, 2004. "Optimal Recursive Refinancing and the Valuation of Mortgage-Backed Securities," NBER Working Papers 10422, National Bureau of Economic Research, Inc.
    9. Thorsten Moenig, 2021. "Efficient valuation of variable annuity portfolios with dynamic programming," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 88(4), pages 1023-1055, December.
    10. Potts, Tom L. & Reichenstein, William, 1995. "Analysis of U.S. savings bonds," Financial Services Review, Elsevier, vol. 4(1), pages 41-56.
    11. Lim, Terence & Lo, Andrew W. & Merton, Robert C. & Scholes, Myron S., 2006. "The Derivatives Sourcebook," Foundations and Trends(R) in Finance, now publishers, vol. 1(5–6), pages 365-572, April.
    12. James B. Kau & Lu Fang & Henry J. Munneke, 2019. "An Unintended Consequence of Mortgage Financing Regulation – a Racial Disparity," The Journal of Real Estate Finance and Economics, Springer, vol. 59(4), pages 549-588, November.
    13. Frank J. Navratil, 1985. "The Estimation Of Mortgage Prepayment Rates," Journal of Financial Research, Southern Finance Association;Southwestern Finance Association, vol. 8(2), pages 107-117, June.
    14. Agarwal, Sumit & Ambrose, Brent W. & Chomsisengphet, Souphala & Liu, Chunlin, 2006. "An empirical analysis of home equity loan and line performance," Journal of Financial Intermediation, Elsevier, vol. 15(4), pages 444-469, October.
    15. Sarkar, Sudipto & Hong, Gwangheon, 2004. "Effective duration of callable corporate bonds: Theory and evidence," Journal of Banking & Finance, Elsevier, vol. 28(3), pages 499-521, March.
    16. Jin, Xin & Maheu, John M. & Yang, Qiao, 2022. "Infinite Markov pooling of predictive distributions," Journal of Econometrics, Elsevier, vol. 228(2), pages 302-321.
    17. Scott Robertson & Zhe Cheng, 2015. "Endogenous Current Coupons," Papers 1510.02010, arXiv.org.
    18. Hendershott, Patric H. & Van Order, Robert, 1989. "Integration of mortgage and capital markets and the accumulation of residential capital," Regional Science and Urban Economics, Elsevier, vol. 19(2), pages 189-210, May.
    19. Jean-David Fermanian, 2013. "A Top-Down Approach for Asset-Backed Securities: A Consistent Way of Managing Prepayment, Default and Interest Rate Risks," The Journal of Real Estate Finance and Economics, Springer, vol. 46(3), pages 480-515, April.
    20. Czellar, Veronika & Karolyi, G. Andrew & Ronchetti, Elvezio, 2007. "Indirect robust estimation of the short-term interest rate process," Journal of Empirical Finance, Elsevier, vol. 14(4), pages 546-563, September.

    More about this item

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:2340. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: the person in charge (email available below). General contact details of provider: https://edirc.repec.org/data/nberrus.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.