Prepayment Risk-and Option-Adjusted Valuation of MBS

Abstract

This exploration of risk-neutrality in MBS prepayments introduces option-adjusted valuation of MBS with consideration of prepayment risk, i.e., the risk that future prepay speeds systematically drift away from a model. A new measure, prepayment risk- and option-adjusted spread (prOAS), is suggested to replace the traditional option-adjusted spread, which varies widely across instruments. PrOAS levels the playing field by assuming that all liquid MBS and their derivatives are traded flat to the same debenture curve, on a risk- and option-adjusted basis. There are two alternative and theoretically equivalent methods of pricing with prOAS: 1) solving pricing PDEs with risk terms explicitly for pass-throughs using the active-passive decomposed prepay model, and 2) using a risk-neutral prepayment model, which is more universal. Although the prOAS method generally works well in case studies, there are some exaggerated dynamics of prices of risk and market dislocation in times of panic that offer arbitrage opportunities.