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Valuation of Residential Mortgage-Backed Securities- A research on valuation
approaches -Master BMI ThesisFaculty of Applied SciencesVrije UniversiteitMustafa
DuruSupervisor: drs. Dennis Roubos10-06-2009
Table of Contents# TOC \o "1-3" \h \z \u ## HYPERLINK \l "_Toc233127703" ##1

Introduction
# PAGEREF _Toc233127703 \h ##1### HYPERLINK \l
"_Toc233127704" ##2
Prepayment # PAGEREF _Toc233127704 \h ##4### HYPERLINK \l
"_Toc233127705" ##2.1
Twelve-Year Prepaid Life
# PAGEREF _Toc233127705 \h
##5### HYPERLINK \l "_Toc233127706" ##2.2 Conditional Prepayment Rate (CPR) #
PAGEREF _Toc233127706 \h ##5### HYPERLINK \l "_Toc233127707" ##2.3
FHA
Experience # PAGEREF _Toc233127707 \h ##5### HYPERLINK \l "_Toc233127708" ##2.4
PSA Model
# PAGEREF _Toc233127708 \h ##6### HYPERLINK \l "_Toc233127709"
##3
Cash Flow Structure of an MBS # PAGEREF _Toc233127709 \h ##7### HYPERLINK \l
"_Toc233127710" ##3.1
Cash Flows without Prepayment # PAGEREF _Toc233127710 \h
##7### HYPERLINK \l "_Toc233127711" ##3.2 Cash Flows with Prepayment
# PAGEREF
_Toc233127711 \h ##8### HYPERLINK \l "_Toc233127712" ##4
The models # PAGEREF
_Toc233127712 \h ##10### HYPERLINK \l "_Toc233127713" ##4.1A 3-factor Valuation
Model for Mortgage-Backed Securities
# PAGEREF _Toc233127713 \h ##10###
HYPERLINK \l "_Toc233127714" ##4.2 Valuation Model with Maximum Likelihood
Techniques # PAGEREF _Toc233127714 \h ##12### HYPERLINK \l "_Toc233127715" ##4.3
Valuation Model with Suboptimal Prepayment Decision # PAGEREF
_Toc233127715 \h ##17### HYPERLINK \l "_Toc233127716" ##4.4Valuation Model Based on
Rational Decisions
# PAGEREF _Toc233127716 \h ##20### HYPERLINK \l
"_Toc233127717" ##5
The Conclusion
# PAGEREF _Toc233127717 \h ##23###
HYPERLINK \l "_Toc233127718" ##Appendix A: Derivation of Monthly Mortgage Payment
# PAGEREF _Toc233127718 \h ##26###
IntroductionFinancial customers who have bought structured products such as the

Mortgage-Backed Securities (hereinafter MBS) and the Collateralized Debt
Obligations (hereinafter CDO) had issues with valuation of these products. This was
because of the underlying structure which gives rise to complexity. Since those
products take a large place in the financial markets, one of the reasons for the
emergence of the crisis is that those products have not always been risk free as
assumed. The Residential Mortgage-Backed Securities (hereinafter RMBS) in which
residential mortgage loans are being passed through to investors in the form of
packages, have been assigned the best possible credit ratings by rating agencies.
Those ratings have given the impression to the investors that the underlying
mortgage loans bring along almost no credit risk. As a result, they have invested
without hesitation of credit risk and the accompanying consequences. When early
2007 the first problems began to stand out and each time piled up, the RBMS seemed
not to be risk free as assumed. The RMBS with a rating lower than their
creditworthiness could not get their part of interest and principal payments. The
matter was, in particular, the speed of how the problems piled up and spread over
the whole market within a short course of time. Due to the complexity of the
products and lack of adequate information, no one could exactly tell where the
problems were stated and where they came from. It is expected that the next few
years these valuation problems will continue to occur because the context is still
complicated from a technical perspective.As mentioned above, mortgages are used to
produce MBS#. They are gathered in a pool and this pool of mortgages are sliced in
small pieces and finally sold to the investors as packages. We would like to give
some brief introduction about mortgages before we go into the MBS. Fabozzi gives
the definition of a mortgage in his book the Handbook of Fixed Income Securities as
follows: A mortgage loan is a loan secured by the collateral of some specified
real estate property, which obliges the borrower to make predetermined series of
payments. A mortgage is a contract between the lender (mortgagee) and the borrower
(mortgagor) in which the mortgagee has the right of foreclosure on the loan in case
the mortgagor defaults.Types of real estate properties that can be mortgaged are
represented as follows:#Figure # SEQ Figure \* ARABIC #1#: Types of real estate
propertiesResidential properties include houses, cooperatives and apartments while
the non-residential properties include commercial and farm properties etc. We will
restrict us to the residential properties since we are interested in valuation of
RMBS.There are several types of mortgage loans that are applicable to residential
properties. The most common type is level payment, in other words fixed-rate
mortgages. Other types are graduated-payment mortgages, growing-equity mortgages,
adjustable-rate mortgages, fixed-rate tiered-payment mortgages, balloon mortgages,
two-step mortgages and last but not least fixed/adjustable-rate mortgage hybrids.
We will restrict us to the most common type of fixed-rate mortgages.In fixed-rate
mortgages the borrower has the obligation to pay a predetermined equal amount on a
monthly basis. A monthly amount consists of interest payment and repayment of a
portion of the outstanding mortgage balance. Below you find the formula that
calculates the monthly mortgage payment [See Fabozzi-1995]:# EMBED Equation.3 ####
# STYLEREF 1 \s #1### SEQ Figuur \* ARABIC \s 1 #1#where MP is monthly mortgage
payme##############################################################################
###############################n#t# #(# )##M#B#0# #i#s# #o#r#i#g#i#n#a#l#
#m#o#r#t#g#a#g#e# #b#a#l#a#n#c#e# #(# )##i# #i#s# #s#i#m#p#l#e# #m#o#n#t#h#l#y#
#i#n#t#e#r#e#s#t# #r#a#t#e# #(#a#n#n#u#a#l# #i#n#t#e#r#e#s#t# #r#a#t#e#/#1#2#)##n#
#i#s# #n#u#m#b#e#r# #o#f# #m#o#n#t#h#s# # ##A#n# #i#m#p#o#r#t#a#n#t# #i#s#s#u#e#
#f#o#r# #t#h#e# #i#n#v#e#s#t#o#r#s# #o#f# #t#h#e# #R#M#B#S# #i#s# #t#h#e#
#p#r#e#p#a#y#m#e#n#t# #r#i#s#k#.# #E#a#c#h# #h#o#m#e#o#w#n#e#r# #h#a#s# #t#h#e#
#o#p#t#i#o#n# #t#o# #p#r#e#p#a#y# #t#h#e# #w#h#o#l#e# #o#r# #a# #part of the
outstanding mortgage balance regardless of time to maturity while there is no
penalty imposed. This results in uncertainty for the investor because he/she never
knows whether the mortgage will be prepaid 1 year or 30 years after the agreement.
There are different motives why a mortgagor prepays. Mortgagors prepay the entire
mortgage if they sell their home for example for personal reasons. It is also a
common practice that the mortgagors refinance a part or the whole if the current
mortgage rates fall by a sufficient amount below the contract rate. Refinancing
costs should be taken here into consideration. Another possibility is that the
mortgager defaults and as a result the collateral is repossessed and sold.If we
assume a pool consisting of thousands of mortgages of which each one bears
prepayment risk and as a result each one has different cash flow structures, we can
understand how complicated the valuation of such an instrument is. Prepayment
models arise here in order to reflect the reality as much as possible. We will
discuss this topic entirely later in the upcoming chapters.The purpose of this
thesis is to provide a quantitative approach of how the MBS may be valued. After
giving some introduction to the topic, we will go further with the challenging
issues such as generic prepayment models, changes in cash flow structures as a
result of prepayments and valuation of various models by well-known professors in
this area. We will see how they embed (some of) those issues into their valuation
models.
PrepaymentAs mentioned earlier, there are different motives why a mortgagor

prepays. In other words, a variety of economic, demographic and geographic factors
influence a mortgagors prepayment decision. The most common factors are interest
rates, burnout, seasoning, seasonality, heterogeneity and overall economy#.
Prepayment is directly related with interest rates. As interest rates fall below
the mortgage coupon rate, mortgagors will have the incentive to prepay their loan.
Historical research shows that not all mortgagors prepay even if it is favourable
to do so. Burnout phenomenon arises here.Heterogeneity of individual mortgagors is
closely related to the burnout phenomenon. Burnout of a mortgage pool means that
the mortgagors will remain in the pool if the interest rates decline below the
mortgage coupon rate while others will prepay and leave the pool through
refinancing. Those who leave the pool are regarded as being in an interest rate
sensitive layer while sitters are regarded as insensitive. In other words, the
higher the fraction of the pool that has already prepaid, the less likely are those
remaining in the pool to prepay at any interest rate level. This burnout effect
causes heterogeneity in the pool.Seasoning refers to the aging of mortgage loans
and can be described as the increasing prepayment incentive of borrowers who are
willing to prepay their mortgages if they have not prepaid yet. The Public
Securities Association model (also known as the PSA aging ramp) assumes that
prepayment rates increase linearly in the first thirty months of the contract
before levelling off.Seasonality measures the correlation between prepayment rates
and the corresponding month of the year. As one might expect, the seasonal increase
do occur in the spring and gradually reaches a peak in the late summer and declines
in the fall and the winter, with the school year calendar and the weather as the
driving forces behind the seasonal cycle.There has been developed a variety of
models to forecast the prepayment behaviour and to represent the prepayment rates
and as a result, the timing and the amounts of the cash flows. Prepayment rates
tend to fluctuate with interest rates, coupon and age of the underlying mortgage as
well as with non-economic factors such as burnout and seasoning. Next section
describes different types of prepayment models.Twelve-Year Prepaid LifeThis
approach has ever been an industry standard. Twelve-year life assumes that there
will not be any prepayment during the first twelve year of the mortgage life and
then suddenly the mortgage will fully prepay at twelfth year. This approach seems
not to give reliable results since prepayment itself tend to fluctuate with
interest rates and other factors.Conditional Prepayment Rate (CPR)CPR for a given
period is the percentage of mortgages outstanding at the beginning of the period
that terminates during that period. The CPR is usually expressed on an annualized
basis, whereas the term single monthly mortality (SMM) refers to monthly prepayment
rates [The Handbook of Fixed Income Securities, 1995 - Fabozzi]. More specifically,
SMM indicates, for any given month, the fraction of mortgages principal that had
not prepaid by the beginning of the month but does prepay during the month. The
relationship between the CPR and SMM can be formulated as:# EMBED Equation.3 ####
STYLEREF 1 \s #2### SEQ Figuur \* ARABIC \s 1 #1#An approximation to the above
formula is:# EMBED Equation.3 #### STYLEREF 1 \s #2### SEQ Figuur \* ARABIC \s 1
#2#In the early years of the mortgage pool, prepayment occurs rarely in comparison
to the rest of the period. Taking a constant CPR will give rise to misleading
results since the prepayment in those years will be overestimated. In order to
handle this shortcoming, Public Securities Association (PSA) model has been
developed. This model combines Federal Housing Administration (FHA) experience with
the CPR method.FHA ExperienceFHA is one of the federal agencies who provides
insurance to mortgages of the qualified borrowers. FHA builds yearly a survivor
table. This table consists of a row of thirty numbers that each represents the
annual survivorship rates of FHA-insured mortgages. The prepayment rates are
derived from this table. Although FHA experience is not often being used nowadays,
this has been a widely used prepayment model. This model is based on historical
prepaid mortgages and therefore is unable to project the future prepayments.PSA
ModelPSA model has been developed by combining FHA experience with CPR method. This
method implies that the prepayment is zero at the initial month and each month
increases with increments of 0.2% up to 30 months and then levels off till the end.
Thus there is a linear increase from 0% to 6% until the thirtieth month and then it
remains constant. This is called 100% PSA. Multiples of PSA are available
employing different coefficients to the slope. For 150% PSA the CPR will be 0.3% in
month one and increase with the increments of 0.3%. See the figure below for an
illustration:#Figure # STYLEREF 1 \s #2### SEQ Figure \* ARABIC \s 1 #1#
Cash Flow Structure of an MBSSince we have worked out the prepayment phenomenon,
one might expect to discuss the cash flow structure with and without the prepayment
effect.Cash Flows without PrepaymentWe assume that the mortgage pool consists of
fixed rate loans without prepayment of any mortgagor. Then the equal monthly
instalments are:# EMBED Equation.3 #### STYLEREF 1 \s #3### SEQ Figuur \*
ARABIC \s 1 #1#where MP is monthly mortgage paym#e#n#t# #(# )##M#B#0# #i#s#
#o#r#i#g#i#n#a#l# #m#o#r#t#g#a#g#e# #b#a#l#a#n#c#e# #(# )##i# #i#s# #s#i#m#p#l#e#
#m#o#n#t#h#l#y# #i#n#t#e#r#e#s#t# #r#a#t#e# #(#a#n#n#u#a#l# #i#n#t#e#r#e#s#t#
#r#a#t#e#/#1#2#)##n# #i#s# #n#u#m#b#e#r# #o#f# #m#o#n#t#h#s#.# ###T#h#e#
#r#e#m#a#i#n#i#n#g# #p#r#i#n#c#i#p#a#l# #b#a#l#a#n#c#e# #a#t# #m#o#n#t#h# #t#
#w#i#l#l# #t#h#e#n# #b#e#:#### #E#M#B#E#D# #E#q#u#a#t#i#o#n#.#3# # ##########
#S#T#Y#L#E#R#E#F# #1# #\#s# ###3####### #S#E#Q# #F#i#g#u#u#r# #\#*# #A#R#A#B#I#C#
#\#s 1 #2#where N is the maturity of the mortgage in months.The initially scheduled
interest payment at month t is:# EMBED Equation.3 #### STYLEREF 1 \s #3### SEQ
Figuur \* ARABIC \s 1 #3#The total cash flow at month t is the change of principal
balance from t-1 to t and the interest rate excluding the service fee:# EMBED
Equation.3 #### STYLEREF 1 \s #3### SEQ Figuur \* ARABIC \s 1 #4#whereC is the
coupon rate of the MBS andS# is the servicing fee.Cash Flows with PrepaymentCash
flows with prepayment option differ from those without prepayment which could be
considered as a risk-free bond. We assume that there are in total K mortgagers in
the pool and each one owns the same amount of mortgage loan. This implies that we
could switch the concept of prepayment ratio measured in terms of money into the
ratio measured in terms of number of remaining mortgagors. We also assume that
there is no partial prepayment. In case of partial prepayment, each mortgagor will
tend to prepay in different amounts caused by different factors mentioned earlier.
This will add another dimension of complexity to the actual problem. We should then
not only be interested in number of prepaid mortgagors but also the amount of each
prepayment. However, if prepayment occurs, the mortgage will be fully prepaid.
Denote the random variable # EMBED Equation.3 ###the number of mortgagors who
prepay up to t.Then the actual principal balance for month t is expressed in terms
of Lt and K is# EMBED Equation.3 ###,# STYLEREF 1 \s #3### SEQ Figuur \* ARABIC \s
1 #5#and the actual interest at month t is# EMBED Equation.3 #### STYLEREF 1 \s
#3### SEQ Figuur \* ARABIC \s 1 #6#The total cash flow at month t is the change of
the actual principal balance from t-1 to t and the interest rate excluding the
service fee:# EMBED Equation.3 #### STYLEREF 1 \s #3### SEQ Figuur \* ARABIC \s 1
#7#If we work the equation out:# EMBED Equation.3 #### EMBED Equation.3 ####
STYLEREF 1 \s #3### SEQ Figuur \* ARABIC \s 1 #8#where# EMBED Equation.3 ####
EMBED Equation.3 ###
The modelsIn this chapter we would like to present various well-known models. We
will discuss the valuation model of Stanton (1995) in which the prepayment model is
based on rational decisions by mortgage holders; the model of Schwartz and Torous
(1989) who develop their model using maximum likelihood techniques to estimate
prepayment function; the model of Dunn and McConnell (1981) based on suboptimal
prepayment decision and the 3-factor valuation model of Kariya, Ushiyama and Pliska
which is an extended framework of the Kariya&Kobayashi valuation model (2000). Of
course, we can discuss more models but since those mentioned above have been a
starting point for investors and financial engineers, we will restrict us to these
basic frameworks. Finally, in the last chapter we will compare those models on
their abilities.A 3-factor Valuation Model for Mortgage-Backed SecuritiesThe onefactor MBS-pricing model of Kariya and Kobayashi (hereinafter KK (2000)) is
extended to a 3-factor model through separating the mortgage rate process from the
short-term interest rate process which are highly correlated with each other and
including the equity factor which is related to rising housing prices. This model
assumes that the prepayment behaviour is heterogeneous and embeds this into the
valuation while some other models assume that the prepayments are homogeneous and
the value of the prepayment option is regarded as a gross or lump-sum value and the
value of MBS will then be decomposed into a prepayment option part and the value of
a riskless bond.In KK (2000) model, by a general no-arbitrage pricing theory for a
discrete time framework, the no-arbitrage value at time m of the MBS with maturity
N using the cash flow structure in section 3.2 is given by# EMBED Equation.3 ####
STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #1#where# EMBED Equation.3 ####
EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #2#with# EMBED
Equation.3 ### (h=1/12)# STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #3#{rj} is
the short-term riskless interest rate process and # EMBED Equation.3 ### is the
conditional expectation at m under a risk neutral measure for the interest rate
process {rj}, the mortgage rate process {Rj} and the housing price level {Pj}.
Here # EMBED Equation.3 ### randomly discounts a cash flow at n to value at m.In
KK (2000) model, prepayment in a mortgage pool takes place at n when the difference
between the initial mortgage rate R0 and the current rate Rn first exceeds his
incentive threshold for the first time. If we assume that each mortgager has their
own threshold dk, the condition for the prepayment can be formulated as follows:#
EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #4#KK (2000)
assumed that the mortgage rate process {Rj} and the interest rate process {rj} are
highly correlated with each other, so the {rj} process determines the prepayment
due to refinancing via 4.4 and the discount factor in 4.3. The threshold dk, which
in principle depends on time and different variables, is assumed constant over time
for sake of simplicity.Another factor that affects the prepayment behaviour is the
equity factor according to Kariya, Ushiyama and Pliska (2002). They call Pn the
housing price level at time n and the k-th mortgagor sells his house if the
difference of current log-price and the initial log-price exceeds his threshold
which is conditioned as follows:# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ
Figuur \* ARABIC \s 1 #5#This threshold is also taken constant over time for
simplicity.After giving the conditions, they specify those three factors affecting
the prepayment as follows:# EMBED Equation.3 ### (discrete time Vasicek model)#
STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #6## EMBED Equation.3 ### (discrete
time Vasicek model)# STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #7#where # EMBED
Equation.3 ###, # EMBED Equation.3 ###, h=1/12 and the # EMBED Equation.3 ###s
are various scalar parameters.# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ
Figuur \* ARABIC \s 1 #8#where # EMBED Equation.3 ### , the volatility (# EMBED
Equation.3 ###) is assumed to be constant and the parameter # EMBED Equation.3
### satisfies # EMBED Equation.3 ###. The value # EMBED Equation.3 ### is
explained as the proportion of a recent change in price brought into a change in
the drift. The greater the # EMBED Equation.3 ### is, the more volatile the drift
is, though it depends on the volatility # EMBED Equation.3 ######.# ###
#E#M#B#E#D# #E#q#u#a#t#i#o#n#.#3# # ####### #a#r#e# #a#s#s#u#m#e#d# #t#o# #b#e#
#i#.#i#.#d#.# #a#s# #3#-#d#i#m#e#n#s#i#o#n#a#l# #n#o#r#m#a#l# #r#a#n#d#o#m#
#v#a#r#i#a#b#l#e#s# #w#i#t#h# ### #E#M#B#E#D# #E#q#u#a#t#i#o#n#.#3# # #######
#a#n#d# #c#o#v#a#r#i#a#n#c#e# #m#a#t#r#i#x# ##,# #w#h#e#r#e#### #E#M#B#E#D#

#E#q#u#a#t#i#o#n#.#3# # #########T#h#e#y# #f#i#n#a#l#i#z#e# #t#h#e# #m#o#d#e#l#
#u#s#i#n#g# #t#h#e# #f#o#l#l#o#w#i#n#g# #a#s#s#u#m#p#t#i#o#n# #s#i#n#c#e# #t#h#e#
#d#i#s#t#r#i#b#u#t#i#o#n# #o#f# #t#h#e# #t#h#r#e#s#h#o#l#d#s# #p#l#a#y#s# #a#n#
#i#m#p#o#r#t#a#n#t# #r#o#l#e# #i#n# #d#e#t#e#r#m#i#n#i#n#g# #t#h#e#
#p#r#e#p#a#y#m#e#n#t# #a#n#d# #a#s# #a# #r#e#s#u#l#t# #t#h#e# #p#r#i#c#e# #o#f#
#a#n# #M#B#S#:##T#h#e# #K# #p#a#i#r#s# #o#f# #r#a#n#d#o#m# #v#a#r#i#a#b#l#e#s# ###
#E#M#B#E#D# #E#q#u#a#t#i#o#n#.#3# # ####### #a#r#e# #i#.#i#.#d#.# #w#i#t#h# #2##d#i#m#e#n#s#i#o#n#a#l# #n#o#r#m#a#l# #d#i#s#t#r#i#b#u#t#i#o#n# #N#(##,##)#,#
#w#h#e#r#e#### #E#M#B#E#D# #E#q#u#a#t#i#o#n#.#3# # ####### #a#nd # EMBED Equation.3
#### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #9#It is possible to estimate
the expectations stated in 4-2 and worked out above, using Monte Carlo simulation
in order to calculate the theoretical value of the MBS.Valuation Model with Maximum
Likelihood TechniquesSchwartz and Torous (1989) have developed an empirical
valuation using maximum likelihood techniques. They have estimated the prepayment
function by a proportional-hazards model using the historical information from the
past GNMA# experience. More specifically, the influence of various explanatory
variables or covariates on the mortgagors prepayment decision was estimated. They
have also explicitly modeled the effects of seasoning. They have finally come with
a second order partial differential equation and used Monte Carlo simulation
methods to solve the equation that is subject to boundary and terminal conditions
which characterize the particular mortgage-backed security.They have modeled the
prepayment function by a proportional-hazards model as follows:# EMBED Equation.3
###,# STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #10#where the base-line hazard
function # EMBED Equation.3 ### is given by the log-logistic hazard function#
EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #11#In
equation 4-10, # EMBED Equation.3 ### is the vector of explanatory variables which
will be formulated below and # EMBED Equation.3 ### is the vector of coefficients.
Equation 4-11 measures the probability of prepayment under homogeneous conditions
(# EMBED Equation.3 ###).Schwartz and Torous employ the refinancing behavior of
mortgagers into the prepayment function using the following covariate:# EMBED
Equation.3 ###, # EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \*
ARABIC \s 1 #12#where c stands for contract rate and l for long-term Treasury rate
that is applied at time t-s. This covariate represents the relationship between
rates at which the mortgage may be refinanced and the contract rate on the
mortgage. More specifically, if available refinancing rate is less than the
contract rate, there exists an incentive to prepay. The larger # EMBED Equation.3
### is, the greater is this incentive to prepay.Another covariate that accelerates
the prepayment when the refinancing rates are sufficiently lower than the contract
rate is:# EMBED Equation.3 ###, # EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ
Figuur \* ARABIC \s 1 #13##To be able to represent the burnout effect, the
following covariate has been used:# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ
Figuur \* ARABIC \s 1 #14#where # EMBED Equation.3 ### represents the dollar
amount of the pool outstanding at time t while # EMBED Equation.3 ### is the
outstanding in the absence of prepaid portion. The last covariate employs the
seasonality into the prepayment function which is represented as follows:# EMBED
Equation.3 ### # EMBED Equation.3 ### # EMBED Equation.3 #### STYLEREF 1 \s
#4### SEQ Figuur \* ARABIC \s 1 #15#Given the prepayment function with four
explanatory variables and the past GNMA prepayment experience, a statistical
maximum likelihood estimation (MLE) of those variables is possible since those
variables influences the mortgagors prepayment decision. The parameters that will
be estimated are the prepayment functions parameter values represented within #
EMBED Equation.3 ### with the inclusion of covariates represented within # EMBED
Equation.3 ###. We will restrict us to the prepayment function modeled above and
the valuation formula of an MBS which will be discussed below and not go further
into detail how those values are estimated using MLE to have this paper to the
point.
In order to value an MBS, Schwartz and Torous first presented the
payout rate and the principal outstanding of a default-free fixed-rate fully
amortizing mortgage. In a continuous-time valuation model the payout rate of a
mortgage with a contract rate c and maturing at T years is:# EMBED Equation.3 ####
STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #16#and the principal outstanding at
time t is:# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1
#17#where P(0) is the principal of mortgage at origination.They have made
couple of assumptions before coming with the partial differential equation. Those
assumptions are:Risk-free interest rate r (short-term rate) and default-free bond
yield l (long-term rate) are taken as term structure of interest ratesDynamics of r
and l (following Brennan and Schwartz (1982)) are assumed as # EMBED Equation.3
#### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #18## EMBED Equation.3 ####
STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #19#where z1 and z2 are standardized
Wiener processes and their increments are correlated with correlation coefficient
###################################################################################
###################################################################################
#################################################################:#### #E#M#B#E#D#
#E#q#u#a#t#i#o#n#.#3# # ########## #S#T#Y#L#E#R#E#F# #1# #\#s# ###4####### #S#E#Q#
#F#i#g#u#u#r# #\#*# #A#R#A#B#I#C# #\#s# #1# ###2#0####P#r#e#p#a#y#m#e#n#t#
#r#a#t#e# #i#s# #a#s#s#u#m#e#d# #t#o# #b#e# #### #E#M#B#E#D# #E#q#u#a#t#i#o#n#.#3#
# ########## #S#T#Y#L#E#R#E#F# #1# #\#s# ###4####### #S#E#Q# #F#i#g#u#u#r# #\#*#
#A#R#A#B#I#C# #\#s# #1# ###2#1####w#h#e#r#e# #t#h#e# #t#i#m#e#-#v#a#r#y#i#n#g#
#x#(#t#)# #d#e#n#o#t#e#s# #t#h#e# #h#i#s#t#o#r#y# #o#f# #p#a#s#t# #i#n#t#e#r#e#s#t#
#rates and y(t) the burnout effect. According to Ramaswamy and Sundaresan (1986)
the state variable x(t) is defined by# EMBED Equation.3 ###, # EMBED Equation.3
#### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #22#This exponential average of
historical bond yields captures the effects of past refinancing rates on current
prepayment decisions. Its stochastic differential equation is given by# EMBED
Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #23#The burnout
effect y(t) captures the heterogeneity in mortgagors and its stochastic
differential equation is given by# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ
Figuur \* ARABIC \s 1 #24#Given the above assumptions the value of an MBS is given
by# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #25#The
PDE that the value of an MBS must satisfy is given by# EMBED Equation.3 ###
# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC
\s 1 #26#wh##################################################e#r#e# ##1#
#d#e#n#o#t#e#s# #t#h#e# #m#a#r#k#e#t# #p#r#i#c#e# #o#f# #s#h#o#r#t#-#t#e#r#m#
#i#n#t#e#r#e#s#t# #r#a#t#e# #r#i#s#k#.##G#i#v#e#n# #t#h#a#t# #t#h#e#
#m#o#r#t#g#a#g#e# #i#s# #f#u#l#l#y# #a#m#o#r#t#i#z#i#n#g#,# #t#h#e#
#f#o#l#l#o#w#i#n#g# #t#e#r#m#i#n#a#l# #b#o#u#n#d#a#r#y# #c#o#n#d#i#t#i#o#n#
#m#u#s#t# #b#e# #s#a#t#i#s#f#i#e#d# #a#s# #w#e#l#l#:#### #E#M#B#E#D#
#E#q#u#a#t#i#o#n#.#3# # ########## #S#T#Y#L#E#R#E#F# #1# #\#s# ###4####### #S#E#Q#
#F#i#g#u#u#r# #\#*# #A#R#A#B#I#C# #\#s# #1# ###2#7###which deduces that there will
be no prepayment at the maturity.The coefficients of the PDE in 4-26 depend upon
the parameters of the interest rate processes. To be able to implement the MBS
valuation in light of the previously estimated prepayment function, these
parameters should be estimated using MLE as well. Below you find a table with the
estimation results corresponding to a specific time period.#Table # STYLEREF 1 \s
#4### SEQ Table \* ARABIC \s 1 #1#The estimated parameters are based on data which
is collected from 1982 until 1987. Data consists of two types of information,
namely short-term Certificates of Deposit (CD) and long-term U.S. Treasury bonds.
The estimated parameters a1 and b1 from the drift of the short-term interest rate
process are statistically significant while the estimated parameters a2, b2 and c2
from the drift of the long-term interest rate process are insignificant. This
justifies the theory that under no-arbitrage arguments, long term interest rates
have no drift and follow a random walk. Finally, Monte Carlo simulation methods
are employed to solve the PDE in equation 4-26, subject to terminal boundary
condition in equation 4-27. Since the insignificance of the coefficients of the
long-term interest rate process holds, Monte Carlo simulation methods require that
r and l are generated by the following risk-adjusted processes:# EMBED Equation.3
#### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #28## EMBED Equation.3 ####
STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #29#Further to this, the monthly cash
flows of the MBS with the prepayment probability incorporated (which is derived
from the prepayment function) will be discounted at the randomly generated normal
variables corresponding to r and l (also correlated with
###################################################################################
###################################################################################
###################################################################################
######)#.# #T#h#e# #t#o#t#a#l# #p#r#e#s#e#n#t# #v#a#l#u#e# #o#f# #t#h#e#s#e#
#c#a#s#h# #f#l#o#w#s# #r#e#p#r#e#s#e#n#t#s# #t#h#e# #v#a#l#u#e# #o#f# #a#n#
#M#B#S#.# ##V#a#l#u#a#t#i#o#n# #M#o#d#e#l# #w#i#t#h# #S#u#b#o#p#t#i#m#a#l#
#P#r#e#p#a#y#m#e#n#t# #D#e#c#i#s#i#o#n##D#u#n#n# #a#n#d# #M#c#C#o#n#n#e#l#l#
#(#1#9#8#1#)# #i#n#t#r#o#d#u#c#e# #a# #P#D#E# #a#p#p#r#o#a#c#h# #t#o# #v#a#l#u#e#
#t#h#e# #G#N#M#A# #m#o#r#t#g#a#g#e#-#b#a#c#k#e#d# #s#e#c#u#r#i#t#i#e#s# #u#s#i#n#g#
#s#u#b#o#p#t#i#m#a#l# #p#r#e#p#a#y#m#e#n#t# decision of mortgagors.
GNMA
mortgage-backed pass-through securities are issued generally by mortgage bankers,
who are approved by the FHA. Each month the issuer of this security must pass
through the scheduled interest and principal payments on the underlying mortgage
to the holder of the security whether or not the issuer has actually collected
those payments from the mortgagors. If the mortgage bankers default to make the
payments, GNMA undertakes for timely payment of principal and interest. Those
securities are considered to be risk-free instruments.
Dunn and McConnell
firstly introduce the generic model for pricing interest contingent securities
developed by Brennan and Schwartz (1977) and Cox, Ingersoll and Ross (1978) and
then embed the suboptimal prepayment option into the model. The generic model is
derived from the following assumptions:The value of default-free fixed interest
rate security, # EMBED Equation.3 ###, is a function only of the current value of
the instantaneous risk-free rate, r(t), and its term to maturity # EMBED Equation.3
###.This assumption means that the current risk-free interest rate completely
summarizes all information which is relevant for the valuation of fixed-rate
securities, e.g. bonds.The interest rate follows a continuous stationary Markov
process given by the stochastic differential equation# EMBED Equation.3 ####
STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #30#where# EMBED Equation.3 ### k,
m>0,# EMBED Equation.3 ###, ############################# #c#o#n#s#t#a#n#t#,#
#d#z# #i#s# #a# #W#i#e#n#e#r# #p#r#o#c#e#s#s# #w#i#t#h# #E#(#d#z#)#=#0# #a#n#d#
#d#z#2#=#d#t# #w#i#t#h# #p#r#o#b#a#b#i#l#i#t#y# #1#.# #T#h#e# #f#u#n#c#t#i#o#n#
##(#r#)# #i#s# #t#h#e# #d#r#i#f#t# #o#f# #t#h#e# #p#r#o#c#e#s#s#;# #k# #i#s#
#t#h#e# #s#p#e#e#d# #o#f# #t#h#e# #a#d#j#u#s#t#m#e#n#t# #p#a#r#a#m#e#t#e#r#,# #m#
#i#s# #t#h#e# #s#t#e#a#d#y# #s#t#a#t#e# #m#e#a#n# #o#f# #t#h#e# #p#r#o#c#e#s#s#
#a#n#d# #t#h#e# #f#u#n#c#t#i#o#n# ##2#(#r#)# #i#s# #t#h#e# #v#a#r#i#a#n#c#e#.#
#T#h#e# #risk adjustment term, # EMBED Equation.3 ### is proportional to the spot
interest rate, i.e.# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \*
ARABIC \s 1 #31#where q is the proportionality factor and p(r), the price of
interest rate risk, equals the equilibrium expected instantaneous return in excess
of the riskless return per unit of risk for securities which satisfy the first
assumption.Individuals have risk preferences consistent with equation 4-31 and
agree on the specification of equation 4-30.The capital market is competitive;
trading takes place continuously which eliminates arbitrage possibility.The cash
flows # EMBED Equation.3 ### from any security are paid continuously.Assumptions 1
to 5 lead to the model of term structure of interest rates introduced by Cox,
Ingersoll and Ross#. This term structure of interest rates provides the foundation
for the GNMA pricing model according to Dunn and McConnell.Using the assumptions
above, Dunn and McConnell come with the following generic model:# EMBED Equation.3
##### EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #32#with
the initial condition## EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \*
ARABIC \s 1 #33#and with the boundary conditions# EMBED Equation.3 ##### STYLEREF
1 \s #4### SEQ Figuur \* ARABIC \s 1 #34## EMBED Equation.3 ##### STYLEREF 1 \s
#4### SEQ Figuur \* ARABIC \s 1 #35#Dunn and McConnell introduce suboptimal
prepayments and embed this into the generic model. The motivation is that sometimes
mortgagors call their loans at times other than those that would be dictated by the
optimal call policy. There are also cases that occur when r is above rc as
suboptimal prepayments. The prepayments are then suboptimal only in the sense that
the amount of the prepayment exceeds the market value of the debt. The additional
assumptions for this characteristic are:Prepayments which occur when the value of a
GNMA security is less than its remaining principal balance follow a Poisson-driven
process. The Poisson random variable, y, is equal to zero until the loan is called
suboptimal. If y jumps to one, there is a suboptimal prepayment and the security
ceases to exit. The Poisson process dy is given by## EMBED Equation.3 ### # EMBED
Equation.3 ###where # EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \*
ARABIC \s 1 #36# and # EMBED Equation.3 ### is the probability
per unit of time of a suboptimal prepayment at a time to maturity
######################################################## #a#n#d# #i#n#t#e#r#e#s#t#
#r#a#t#e# #r#.##p#r#e#p#a#y#m#e#n#t#s# #w#h#i#c#h# #o#c#c#u#r# #w#h#e#n# #t#h#e#
#v#a#l#u#e# #o#f# #a# #G#N#M#A# #s#e#c#u#r#i#t#y# #i#s# #l#e#s#s# #t#h#a#n# #i#t#s#
#r#e#m#a#i#n#i#n#g# #p#r#i#n#c#i#p#a#l# #b#a#l#a#n#c#e# #a#r#e#
#u#n#c#o#r#r#e#l#a#t#e#d# #w#i#t#h# #a#l#l# #r#e#l#e#v#a#n#t# #m#a#r#k#e#t#
#f#a#c#t#o#r#s# #a#n#d# #a#r#e#,# #t#h#e#r#e#f#o#r#e#,# #p#u#r#e#l#y# #n#o#n#
#s#y#s#t#e#m#a#t#i#c###A#d#d#i#n#g# #t#h#o#s#e# #t#w#o# #n#e#w#
#a#s#s#u#m#p#t#i#o#n#s# #a#n#d# #s#u#b#s#t#i#t#u#t#i#n#g# #f#o#r# ##(#r#)# #a#n#d#
##(#r#)# #f#r#o#m# #4#-#3#0# #a#n#d# #f#o#r# #p#(#r#)# #f#r#o#m# #4#-#3#1#,# #w#e#
#o#b#t#a#i#n#### #E#M#B#E#D# #E#q#u#a#t#i#o#n#.#3# # ########## #S#T#Y#L#E#R#E#F#
#1# #\#s# ###4####### #S#E#Q# #F#i#g#u#u#r# #\#*# #A#R#A#B#I#C# #\#s# #1# ###3#7###
#E#q#u#a#t#i#o#n# #4#-#3#7# #t#o#g#e#t#h#e#r# #w#i#t#h# #t#h#e# #i#n#i#t#i#a#l#
#c#o#n#d#i#t#i#o#n# #4#-#3#3# #a#n#d# #t#h#e# #b#o#u#n#d#a#r#y#
#c#o#n#d#i#t#i#o#n#s# #4#-#3#4# #a#n#d# #4#-#3#5# #c#a#n# #b#e# #solved for the
value of a GNMA MBS.Valuation Model Based on Rational DecisionsThis valuation model
of Stanton (1995) which is assumed as a breakthrough among structural models is
actually an extension of the rational prepayment models. Stanton first lays out the
model through describing prepayment decision process of a single rational mortgagor
and then works the model out in detail. He introduces first the value of a
mortgage liability as a bond price minus the option value of the prepayment. The
bond price here is nothing else than the present value of the remaining cash flow
streams on the mortgage. The call option on bond B at t, Bt, has an exercise price
of # EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #38#where
Ft is the remaining balance at t andXi is the transaction cost of mortgagor i
associated with prepayment.The value of a mortgage liability,# EMBED Equation.3
###, is given by# EMBED Equation.3 ### (l for liability) # STYLEREF 1 \s #4### SEQ
Figuur \* ARABIC \s 1 #39#
where # EMBED Equation.3 ### is the value of
prepayment option to the mortgagor. Since Bt does not depend on the mortgagors
prepayment decision, minimizing the liability value is equivalent to maximizing the
option value.
Further, Stanton distinguishes between endogenous and exogenous
prepayment reasons. An endogenous reason is that the mortgagor prepays his loan if
the refinancing rates are sufficiently below the contract rate. Exogenous reasons
are such as divorce, moving or sale of the house. T#h#e# #l#i#k#e#l#i#h#o#o#d#
#o#f# #a#n# #e#n#d#o#g#e#n#o#u#s# #p#r#e#p#a#y#m#e#n#t# #i#s# #d#e#s#c#r#i#b#e#d#
#b#y# #a# #h#a#z#a#r#d# #f#u#n#c#t#i#o#n# ## #a#n#d# #t#h#e# #l#i#k#e#l#i#h#o#o#d#
#o#f# #a#n# #e#x#o#g#e#n#o#u#s# #p#r#e#p#a#y#m#e#n#t# #i#s# #d#e#s#c#r#i#b#e#d#
#b#y# #a#n#o#t#h#e#r# #h#a#z#a#r#d# #f#u#n#c#t#i#o#n# ##.##
#T#h#e#
#v#a#l#u#e# #o#f# #a# #m#o#r#t#g#a#g#e#-#b#a#c#k#e#d# #s#e#c#u#r#i#t#y# #w#h#o#s#e#
#c#a#s#h# #f#l#o#w#s# #a#r#e# #d#e#t#e#r#m#i#n#e#d# #b#y# #t#h#e#
#p#r#e#p#a#y#m#e#nt behavior of the mortgagor is # EMBED Equation.3 ###(a for
asset)There is a difference between asset and liability values because of the
transaction costs associated with prepayment. These costs paid by the mortgager are
not received by the investor of the MBS. For a given coupon rate and transaction
cost Xi, there is a critical interest rate # EMBED Equation.3 ### such that if #
EMBED Equation.3 ### the mortgagor will optimally prepay. Equivalently, for a
given coupon rate and interest rate # EMBED Equation.3 ###, there is a critical
transaction cost # EMBED Equation.3 ### such that if # EMBED Equation.3 ### the
mortgage holder will optimally prepay. This exercise strategy defines a hazard
function that holds for a single mortgagor. The hazard rate governing prepayment is
given by# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #40#
Probability of total prepayment is given byP(prepayment)=# EMBED Equation.3 ####
STYLEREF 1 \s #4### SEQ Figuur \* ARABIC \s 1 #41#where Pe denotes for the
probability of the prepayment this month if only exogenous prepayment will occur#
andPr denotes for the probability of prepayment this month if it is optimal to
prepay.The assumption that Stanton makes about the interest rate process is that he
employs the one-factor CIR model such as other authors. In this model rt satisfies
the following SDE:# EMBED Equation.3 #### STYLEREF 1 \s #4### SEQ Figuur \* ARABIC
\s 1 #42#On average the interest rate r converges towards to ##################
#a#n#d# #t#h#e# #p#a#r#a#m#e#t#e#r# ## #g#o#v#e#r#n#s# #t#h#e# #r#a#t#e# #o#f#
#t#h#i#s# #c#o#n#v#e#r#g#e#n#c#e# #p#r#o#c#e#s#s#.# ### #E#M#B#E#D#
#E#q#u#a#t#i#o#n#.#3# # ####### #i#s# #t#h#e# #v#o#l#a#t#i#l#i#t#y# #o#f#
#i#n#t#e#r#e#s#t# #r#a#t#e#s#.# #O#n#e# #f#u#r#t#h#e#r# #p#a#r#a#m#e#t#e#r# #q#
#i#s# #n#e#e#d#e#d# #t#o# #v#a#l#u#e# #o#f# #t#h#e# #m#o#r#t#g#a#g#e# #s#i#n#c#e#
#i#t# #s#u#m#m#a#r#i#z#e#s# #r#i#s#k# #p#r#e#f#e#r#e#n#c#e#s# #o#f# #t#h#e#
#r#e#p#r#e#s#e#n#t#a#t#i#v#e# #i#n#d#i#v#i#d#u#a#l mortgagor.Given the CIR model,
one might formulate the value of the mortgage and the optimal exercise strategy
that satisfies the PDE. V(rt,t), the value of an interest rate contingent claim
paying coupons at some rate C(rt,t) must satisfy# EMBED Equation.3 #### STYLEREF 1
\s #4### SEQ Figuur \* ARABIC \s 1 #43#Stanton uses the Crank-Nicholson algorithm
to get a price for an MBS. This algorithm works backward to solve the PDE. This
gives the value of an MBS conditional on the prepayment option remaining
unexercised,# EMBED Equation.3 ###. # EMBED Equation.3 ### is a weighted average
of # EMBED Equation.3 ### and # EMBED Equation.3 ### is the probability that the
mortgage will be prepaid in month t.To summarize Stantons comprehensive valuation
model:Discretize time [0,T] into N steps,# EMBED Equation.3 ###Each step unprepaid
MBS value # EMBED Equation.3 ### is obtained by solving the PDE in equation 4-43
MBS value at each step is given by# EMBED Equation.3 ##### STYLEREF 1 \s #4### SEQ
Figuur \* ARABIC \s 1 #44#Repeat these steps until t0=0
The ConclusionIn this section we discuss the models that are worked out in the
previous section. Of the four models we can easily eliminate two models since they
have major shortcomings. However, those two have surely been enlightenment for
further research.Schwartz and Torous have empirically modeled the prepayment as a
function of some set of explanatory variables using the past prepayment rates.
Their aim was to fit the shape of observed prepayment data, unrestricted by many
theoretical considerations. It is not clear how this model will perform in a
different economic environment. If the interest rate process or mortgage contract
terms would change, mortgage prepayment behavior would also change. Purely
empirical models, such as this model can make no predictions about the magnitude of
this change.Dunn and McConnell have determined the prices and prepayment behavior
together, both depending on the assumed interest rate model. This model links
prepayment and valuation within a single framework, allowing it to address what
would happen in the event of structural shift in the economy. However, their model
implies arbitrage bounds# on mortgage backed securities that are often violated in
practice. Major shortcoming is that mortgagors may not prepay even when it is
optimal to do so.Kariya, Ushiyama and Pliska (KUP) have extended the framework of
Kariya and Kobayashi (2000) through making a distinction between the short-term
rates and the mortgage rates and adding the equity factor which is related to
rising housing prices. This distinction is very important and also holds for all
other models because a decrease in the mortgage rate will tend to lower the MBS
value due to refinancing, whereas this decrease will also tend to increase the MBS
value since the discount factors will increase. Besides this, their framework
directly embeds prepayment behavior into the valuation of an MBS such as that of
Dunn and McConnell. In their prepayment behavior, exogenous reasons are not
included but the model is such that they can easily be embedded. Further to that,
the thresholds in determining prepayments are randomly distributed per mortgagor
but taken constant over time while in reality these should depend upon time and
other factors. This shortcoming is eliminated in Stantons model through
introducing refinancing costs that vary over time.Like Dunn and McConnell and KUP,
the model of Stanton embeds prepayment behavior directly into the valuation and
therefore changes in interest rates will directly effect the cash flow structures
and as a result the value of an MBS. This model extends the model of Dunn and
McConnell in several ways:It explicitly models and estimates the heterogeneity in
the transaction costs faced by mortgagors,Mortgagors make prepayment decisions in
discrete time intervals, rather than continuously.These two features produce
endogenously the burnout effect noted in empirical studies without the need to
specify an ad hoc exogenous burnout factor.The model gives rise to a simple reduced
form representation for prepayment.In light of the above analysis, we find that
Stantons model is more comprehensive in comparison to others. But the model of KUP
answers most of the shortcomings and easy to implement using Monte Carlo simulation
while Stantons model is only a numeric algorithm. However, these two can be
considered as reasonable ones.
Reference ListDunn, K. B., and J. J. McConnell [1981b], Valuation of GNMA

Mortgage-Backed Securities,Journal of Finance 36: 599-617.Fabozzi, F.J. [1995],
The Handbook of Mortgage Backed Securities Fourth Edition,Schwartz, E. S., and
Torous, W. N., [1989], Prepayment and the Valuation of Mortgage-Backed
Securities, Journal of Finance 44: 375-392.Stanton, R. H. [1995], Rational
Prepayment and the Valuation of Mortgage-BackedSecurities, Review of Financial
Studies 8: 677-708.Rom-Poulsen, N. [2007], Semi-Analytical MBS Pricing, J Real
Estate Finan Econ (2007) 34:463498Kariya, T. and Kobayashi, M., [2000], Pricing
Mortgage-Backed Securities (MBS)- A Model Describing the Burnout Effect, AsiaPacific Financial Markets 7, 189 - 204Kariya, T., Ushiyama, F. and Pliska, S.,
[2002], A 3-factor Valuation Model for Mortgage-Backed Securities (MBS), working
paper.Schwartz, E. S., and Torous, W. N., [1992], Prepayment, Default, and the
Valuation of Pass-through Securities, Journal of Business 65: 221-240.Nakamura,
N., [2001], Valuation of mortgage-backed securities based upon a structural
approach, Working paper.Boudhouk, J., M. Richardson, R. Stanton, and R.Whitelaw,
[1997], Pricing mortgage backed securities in a multifactor interest rate
environment: a multivariate density estimation approach, Review of financial
studies, 10, 405 - 446.Collin-Dufresne, P., and Harding, J. P. [1999]. A closed
form formula for valuing mortgages. The Journal of Real Estate Finance and
Economics, 19(2), 13346.
Appendix A: Derivation of Monthly Mortgage PaymentAmount owed at month 0: MB0

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#p#N#(#x#)#=#1# #+# #x# #+# #x#2# #+#& +# #x#N#-#1# #w#i#t#h# #x#=#(#1#+#i#)#
#h#a#s# #a# #s#i#m#p#l#e# #c#l#o#s#e#d#-#f#o#r#m# #e#x#p#r#e#s#s#i#o#n#
#o#b#t#a#i#n#e#d# #f#r#o#m# #o#b#s#e#r#v#i#n#g# #t#h#a#t# #x#p#N#(#x#)# ##"
#p#N#(#x#)# #=# #x#N# ##" #1# #b#e#c#a#u#s#e# #a#l#l# #b#u#t# #the first and last
terms in this difference cancel each other out. Therefore, solving for pN(x) yields
the much simpler closed-form expression which can be formulated as:# EMBED
Equation.3 ###Applying this fact to the amount owed at Nth month:Amount owed at
month N# EMBED Equation.3 ###Since the amount owed at month N must be zero because
the mortgagor agrees to fully pay off, the monthly mortgage payment MP can be
obtained by:# EMBED Equation.3 ###(Source: Wikipedia http://en.wikipedia.org/wiki/Mortgage_Calculator)# Since RMBS is a part of MBS and
we restrict us only to the residential variant, for sake of simplicity, we call the
residential mortgage-backed securities as MBS through the whole paper.# See
Appendix A for a derivation of this formula# A behaviour of regional or national
economy as a whole# A percentage of each mortgage payment made by a borrowerto a
mortgage servicer as compensation for keeping a record of payments, collecting and
making escrow payments, passing principal and interest payments along to the note
holder, etc.Servicing fees generally range from 0.25-0.5% of the remaining
principal balance of the mortgage each month (source: www.investopedia.com)# The
Great majority of mortgagebacked pass-throughs have been issued by three agencies.
The Federal National Mortgage Association (FNMA, or Fannie Mae), the oldest of
these agencies, was established by the federal government in 1938 to help solve
some of the housing finance problems brought on by the Great Depression. In 1968,
Congress divided the original FNMA into two organizations: the current FNMA and the
Government National Mortgage Association (GNMA, or Ginnie Mae). GNMA remains a
government agency within the Department of Housing and Urban Development (HUD),
helping to finance government-assisted housing programs (source: The Handbook of
Fixed Income Securities Fourth EditionFabozzi 1995)# Also known as CIR Model# #
EMBED Equation.3 #### At maturity,
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endogenous reasons such as interest rate.# y transforms natural boundaries of
interest rate grid, # EMBED Equation.3 ###, onto the finite range # EMBED
Equation.3 #### Theoretical MBS value is bounded from above, see equation 4-35####
#PAGE ##PAGE #iii## PAGE #26#a suboptimal prepayment does not occura suboptimal
prepayment occurs
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Table of Contents# TOC \o "1-3" \h \z \u ## HYPERLINK \l "_Toc233127703" ##1

IntroductionFinancial customers who have bought structured products such as the

PrepaymentAs mentioned earlier, there are different motives why a mortgagor

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Reference ListDunn, K. B., and J. J. McConnell [1981b], Valuation of GNMA

Appendix A: Derivation of Monthly Mortgage PaymentAmount owed at month 0: MB0

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