What Constitutes a Good Model? An Analysis of Models for Mortgage Backed Securities

Additional Market Risk Shocks: Prepayment Uncertainty and Option-Adjusted Spreads

“…Panel (C) of Exhibit 4 illustrates estimated changes in current coupon OAS given varying sets of interest rate shocks. The simulated OAS shocks range in value from 0 bps to 28 bps with an average change of 8 bps, which is largely in line with the 10 bps model risk add-on calculated by Heidari and Wu [2004]. Hence, as changes to the interest rate environment begin to affect modeled prepayment speeds, we have established a way to generate, link, and select appropriate OAS shocks (i.e., the largest modeled projections in panel (C) might appeal to the most conservative investment strategies).…”

“…Fall 2016 and Davidson [2005,2008]). OAS serves as a broad measure of model error; however, its primary components are model dependent and vary across market environments (Heidari and Wu [2004]). For any given mortgage security, OAS is constructed to equate the security's model price to "fair value" market quotes.…”

“…There is a strong empirical relationship between a mortgage security's OAS and interest rates (Heidari and Wu [2004]). All else constant, a mortgage security's OAS will widen when interest rates fall because when investors face a greater probability of borrowers exercising their prepayment options, they require a higher premium for taking the prepayment risk.…”

“…1 Historically, practitioners in fixed-income markets have focused on two classical sources of risk, adverse changes in interest rates and volatility. As stress testing has evolved, researchers have identified additional market risk factors that can affect option-adjusted spreads (OAS) and the value of mortgage securities (Kopprasch [1994]; Heidari and Wu [2004]; Levin and Davidson [2005]). 2 We propose including shocks to either mortgage security prepayment rates or option-adjusted spreads, which historically have been calibrated to accompany a corresponding set of interest rate and volatility shocks.…”

“…In contrast, OAS serve as a broader and forward-looking measure of model error, which can encompass prepayment model errors due to misspecification as well as errors in forecasting (Babbel and Zenios [1992]). These shocks can be constructed based upon multiple historical vendor quotes, but their principal components are model dependent and vary across market environments (Heidari and Wu [2004]). Data scarcity is also a concern for non-agency securities.…”