Abstract
Mortgage backed securities (MBS) have embedded options that are dependent on the primary mortgage rate, since this is what homeowners use to make their exercise decision. In valuing MBS in uncertain rate environments, practitioners have traditionally assumed that the primary mortgage rate has a fixed spread to a benchmark interest rate (such as the 10-year Treasury). This naive method is actually inconsistent with the OAS methodology used to price MBS and has performed poorly. In this article the authors present the Citigroup Mortgage Option-Adjusted Term Structure (MOATS) model to derive the mortgage rate in any interest rate scenario. MOATS assumes that the OAS of the current-coupon mortgage is constant and thus projects mortgage rates by taking into account the optionality embedded in the mortgage rate itself. This article gives a detailed description of the MOATS methodology and examines the underlying assumptions. Empirical studies show that the assumptions embedded in MOATS are reasonable and that MOATS outperforms traditional mortgage rate models.
- © 2006 Pageant Media Ltd
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