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Reading 57: Valuing Mortgage-Backed and Asset-Backed Securit

Session 15: Fixed Income: Structured Securities
Reading 57: Valuing Mortgage-Backed and Asset-Backed Securities

LOS e: Evaluate a mortgage-backed security (MBS) using option-adjusted spread (OAS) analysis.

 

 

 

Wanda Brunner is evaluating the two tranches shown below for a hypothetical sequential-pay CMO structure.

Tranche

OAS (bps)

Z-spread (bps)

Effective duration

I

95

100

4.25

II

100

90

4.25

Which CMO tranche should Brunner trade?

A)
Buy Tranche II and sell Tranche I.
B)
Cannot be determined.
C)
Buy Tranche I and sell Tranche II.



 

Tranche I option cost = 100 – 95 = 5 basis points

Tranche II option cost = 100 – 90 = 10 basis points

Tranche I has a higher OAS and lower option cost than Tranche II, and the effective durations of the two tranches are equal. Therefore:

  • Tranche I is undervalued on a relative basis (“cheap”), and we should buy it.
  • Tranche II is overvalued on a relative basis (“rich”), and we should sell it.

Generally speaking, an analyst would like the adjusted spread (OAS) to be:

A)
small.
B)
zero.
C)
big.



Generally speaking, an analyst would like the OAS to be big.

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