LiquidAssets10

Paul Wilken works in the structured product group of a large investment bank. One of his new tasks is to perform valuation analysis on mortgage-backed (MBS) and asset-backed securities (ABS). Wilken needs to familiarize himself with the many measures used to value these types of securities. The first valuation metric that Wilken is to explore is the cash flow yield. Wilken would like to determine the strengths and weaknesses of the cash flow yield. Which of the following assumptions is least likely a limitation of the cash flow yield measure?

A) The computation includes an assumption about the default rate of the underlying loans.

B) The credit risk associated with the underlying loans is constant over the life of the security.

C) MBS or ABSs are held until the final payout based on some prepayment assumption.

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The cash flow yield measure does not rely on any credit risk assumption. (Study Session 15, LOS 53.a)

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Wilken now turns his attention to the nominal spread. Once again he is interested in the strengths and weaknesses of the valuation metric. Which of the following is a limitation of the nominal spread? The nominal spread:

A) contains no adjustment for prepayment risk.

B) is not adjusted for interest rate risk.

C) does not account for inflation.

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The nominal spread does not properly capture the prepayment risk associated with these securities. (Study Session 15, LOS 53.a)

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Wilken has some experience using interest rate lattice models to price interest rate derivatives. He has read that the lattice based backward induction method cannot be used to value a MBS. Which of the following is a reason why this is the case? The lattice based backward induction method is difficult to use because of:

A) prepayments.

B) variable interest rates.

C) the path dependency of cash flows.

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Prepayments depend on the level of the interest rate at a particular point in time and also on the path the interest rate has taken in order to get to a certain level. Backward induction can't easily capture path dependent cash flows.
Prepayments can be incorporated in a model that uses backward induction. (Study Session 15, LOS 53.c)

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Wilken wants to use Monte Carlo simulation in order to value agency passthrough securities. Why must adjustments be made to interest rate paths of the Monte Carlo simulation model? Adjustments must be made to:

A) ensure that the correct prepayments are included.

B) produce the requisite no-arbitrage property.

C) prevent defaults.

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The user must adjust the interest rate paths so that the model retains a no-arbitrage with market values. (Study Session 15, LOS 53.b)

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Wilken turns his attention to interest rate sensitivity measures. In particular he wants to know why there are differences in effective duration quotes between dealer firms. Which of the following is least likely a reason why there exist differences in the effective duration measures in the MBS and ABS markets? Suppliers of effective duration quotes use different:

A) OASs.

B) prepayment models.

C) convexity estimates.

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The convexity metric is not needed to compute the effective duration. (Study Session 15, LOS 53.f)

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Wilken is aware that there are different methods to value an ABS. When should an ABS be valued using the zero-volatility spread approach?

A) When the ABS does not have a prepayment option or the prepayment option is unlikely to be exercised.

B) When the ABS has a prepayment option that is likely to be exercised.

C) When there is no default risk.

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This approach does not consider any prepayment option. (Study Session 15, LOS 53.i)

LiquidAssets10

Which of the following is NOT a major reason why the effective durations reported by dealers and vendors can be very different?

A) Differences in the assumption how yield volatility changes for shocks to the yield curve.

B) Different option-adjusted spreads.

C) Differences in the relationship between short-term interest rates and refinancing rates.

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The major differences in the effective duration among analytical systems providers are attributable to differences in the following: the incremental change in interest rate, the prepayment model, the OAS, and the interest rate/refinancing rate spread assumption.

LiquidAssets10

Why do differences in the size of the rate shock produce different effective durations?

A) The yield curve is not flat.

B) Different rate shocks result in different yield volatility changes.

C) The price-yield relationship is convex.

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If the incremental change in interest rates is too large, the effects of convexity contaminate duration measurements.

LiquidAssets10

The option adjusted spread (OAS) is used to analyze risk by adjusting for the embedded options. Which of the following risks does the OAS reflect?

A) Credit risk.

B) Prepayment risk.

C) Maturity risk.

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The OAS reflects credit risk and liquidity risk.

LiquidAssets10

All of the following are advantages of coupon curve duration EXCEPT it:

A) presumably reflects market expectations.

B) is easy to apply.

C) is limited to generic mortgage-backed securities (MBS).

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It is a disadvantage that it is limited to generic MBS and is not readily applicable to collateralized mortgage obligations (CMO) structures.

LiquidAssets10

Which of the following is a limitation of cash flow duration?

A) It assumes a single prepayment rate over the life of the mortgage backed security.

B) It assumes that the cash flows do not change for a given interest rate shock.

C) It does not take credit risk into account.

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A major criticism of cash flow duration is that it is based on the unrealistic assumption that a single prepayment rate exists over the life of an MBS for any given change in interest rates. The Monte Carlo simulation does allow for changing prepayment rates, and, therefore, effective duration computed using the Monte Carlo simulation is much better than cash flow duration for MBSs

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All of the following are disadvantages of empirical duration EXCEPT:

A) the volatility of the spreads with reference to Treasuries can distort the price reaction to interest rate changes.

B) time series data on mortgage-backed securities may be difficult to obtain.

C) it has no theoretical underpinnings or analytical assumptions.

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The fact that it has no theoretical underpinnings or analytical assumptions is an advantage of empirical duration, not a disadvantage.

LiquidAssets10

Which of the following is least likely an advantage of the empirical duration approach?

A) The volatility of the spread to Treasury securities does not distort how the price of mortgage-backed securities (MBS) reacts to yield changes.

B) The only inputs needed are prices and Treasury yields.

C) It does not rely on any theoretical formulas or assumptions.

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The fact that the volatility of the spreads with reference to Treasuries can distort the price reaction to interest rate changes is a criticism of the empirical duration approach.

LiquidAssets10

The cash flows from mortgage-backed and some asset-backed securities are:

A) virtually free of prepayment risk.

B) interest rate path dependent.

C) interest rate path independent.

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The cash flows from mortgage-backed and some asset-backed securities are interest-rate path dependent.

LiquidAssets10

For a bond with an embedded option where the cash flows are not interest rate path dependent, which of the following valuation approaches should be used?

A) The option-adjusted spread approach with the binomial model.

B) The zero-volatility spread approach with the binomial model.

C) The option-adjusted spread approach with the Monte Carlo simulation model.

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The OAS method recognizes that cash flow changes accompany interest rate changes. Thus, it is suitable to use OAS analysis with ABSs that have a prepayment option that is frequently exercised, and if the cash flows are independent of the interest rate path, OAS should be computed with the binomial model.