Valuation of ABS/MBS

Summaries

Cash Flow Yield (similar to yield to maturity in the bond valuation)

In bond equivalent yield = ((1+Monthly Cash Flow Yeild)^6-1)x2

Nominal spread = Cash flow yield – treasury security with maturity same as the “average life” of the ABS.

Zero-volatility (Z-, static) spread

-          only consider one path of interest rate (the current treasury spot rate). Therefore, it is called zero-volatility.

OAS – similar to that of bond BUT

-          Must use Monte Carlo Simulation because the cash flow depends on both passed and spot interest rate

-          Cash flow to a tranche depends on the balance of another tranche

-          This introduces modeling risk (assumption)

Support tranche has more liquidity risk than PACI

OSA using treasury securities as benchmark means starting with treasury spot rate in the interest rate tree, taking options into account when calculating cash flow and then adding OSA to each interest rate to get the current market price.

Representative paths – consolidated paths for the sake of quick calculation. Price is the weighted average of the representative paths.

Cheap securities – high OAS and low option cost (Z – OAS)

Rich securities – low OAS and high option cost

Duration measures the interest risk.

Cash Flow Duration – Make prepayment assumption (e.g. PSA 120) for cash flow. Construct interest rate trees to find BV+ and BV-.

Coupon Curve Duration – Use coupon curve and assume reducing (increasing) interest rate corresponding to higher (lower) coupons payment. Use the corresponding BV for that coupon payment to calculation duration.

Empirical Duration – Using regression analysis on historical relationship between security price and yield

Credit card ABS or autoloan ABS should use Z-spread because there are no prepayment options or they are usually not exercised.