RT Journal Article
SR Electronic
T1 Overlooked Market Risk Shocks: <em>Prepayment Uncertainty and Option-Adjusted Spreads</em>
JF The Journal of Fixed Income
FD Institutional Investor Journals
SP 5
OP 15
DO 10.3905/jfi.2016.26.2.005
VO 26
IS 2
A1 Alexander N. Bogin
A1 Nataliya Polkovnichenko
A1 William M. Doerner
YR 2016
UL https://pm-research.com/content/26/2/5.abstract
AB 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.TOPICS: MBS and residential mortgage loans, options, factor-based models