## Valuing mortgage-backed and asset-backed securities, Financial Management

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• A cash-flow yield is the discount rate that makes the price of a mortgage-backed or asset-backed security equal to the present value of its cash flows. It is built on three assumptions: i) assumption regarding prepayment and default recovery ii) assuming that the cash flows would be reinvested at the computed cash flow yield, and iii) the assumption that the security will be held by the investor until maturity. These three assumptions can also be considered as major drawbacks of this model.

• The zero-volatility spread is a measure of the spread that the investor would realize over the entire Treasury spot rate curve if a mortgage-backed or asset-backed security is held to maturity.

• The cash flows of mortgage-backed and asset-backed securities are interest rate path dependent; because of this feature, Monte Carlo method is used for valuing these securities instead of binomial model. Monte Carlo simulation is used for valuing mortgage-backed securities, while on-the-run treasury is used for valuing asset-backed securities. The simulation works by generating many scenarios of future interest rate paths. For each month, a monthly interest rate and a mortgage refinancing rate are generated. The monthly interest rates are used for discounting the projected cash flows and the mortgage refinancing rate is used for determining the cash flow because it represents the opportunity cost for the mortgagor.

• A few duration measures that are used for mortgage-backed and asset-backed securities are effective duration, cash flow duration, coupon rate duration and empirical duration.

• Basically, an asset-backed security can have one of the following three characteristics. (Characteristic a) No prepayment option. Example: security backed by credit card receivables. (Characteristic b) Prepayment option is available but borrowers do not show any intention of prepaying when refinancing rates fall below the loan rate. Example: security backed by automobile loans. (Characteristic c) Prepayment option is available and borrowers are willing to prepay when refinancing rates fall below the loan rate. Example: closed-end home equity loans taken by high quality borrowers.

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