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Prepayment Risk- a nd Option-Adjusted Valuation of MBS opportunities for arbitrai^e. Alexander Levin and Andrew Davidson ALEXANDER LEVIN is head ot Valuation i^cvclopment a t Andrew Davidson &: Co., Inc., in Ne w York City. [email protected] ANDREW DAVIDSON IS th e president a nd founder of Andrew Davidson & Co., Inc. SUMMKR 2005 O ption-adjusted spre ad (OAS), while a much better measure than yield or static spread, still tails short i n explaini ng the dynamics of mortgage pricing. The standard OAS typ- ically varies across instruments {pass-throughs, collater- alized mortgage obligations, interest-only securities, principal-only securities), coupons, prepayment option moneyness, an d pool seasoning stages. Premium an d discount MBS are often priced at wider O AS than the current-coupon issues. Premium MB S an d lOs stripped of t premium pools are considered hazardous, an d their higher OAS reflect concerns of understated refinancing. Naturally, the respective POs look rich. In the discount sector, higher OAS reflects the risk associated with possible overstatement of the hous- ing turnover rate. Clearly, these market phenomena defeat the very purpose ofa constant OAS approach. Rich-cheap judg- ments become inconclusive, an d rate shock analysis ca n produce inaccurate hedge ratios.' Like Cheyette [1996] and Cohler, Feldman, an d Lancaster [1997], we attribute the OA S and its variabil- ity to the prepayment risk premium, i.e., possible non- diversifiable deviations of actual future prepayments fix)m a best guess prepay model's forecast. It is the market's fear of systematic bias in prepayment forecasts that leads to a ri sk p remiu m. If prepayments were perfectly predictable, then a n exact, even inefficient, option exercise model should produce a zero OAS to an appropriat e option-trf e benchmark, just a s options an d T H E JOURNAL OF PORTFOHO MANAGEMENT 7 3

jpm prepay 05

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