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

Abstract

Assessments of market risk for economic or regulatory capital typically involve calculating a portfolio’s sensitivity to key risk factor movements. In this article, we describe how to generate shocks to prepayment rates and mortgage security option-adjusted spreads (OAS) conditional on a corresponding set of interest rate shocks. By using historical performance data from multiple model vendors, we show that prepayment rate shocks capture model misspecification but potentially fail to account for other important sources of model error. Mortgage security OAS serves as a broader measure of model error, encompassing both model misspecification and forecasting errors, as well as credit and liquidity risk. While sometimes overlooked, alternative risk factors, such as prepayment and OAS shocks, can have a pronounced effect on the valuation of institutional portfolios with mortgage securities.