cross-ied

The volatility assumption in a Monte Carlo simulation is important, because it determines the:

A) speed of prepayments.

B) level of prepayments.

C) dispersion of future interest rates and the number of possible paths that may be followed.

---

The volatility assumption in a Monte Carlo simulation is important because it determines the dispersion of future interest rates and the number of possible paths that may be followed.

cross-ied

Which of the following statements regarding a mortgage-backed security (MBS) is CORRECT?

A) Backward induction methodology is useful for valuing MBS.

B) Binomial models should not be used for MBS because of path dependency.

C) Path dependency means that MBS prices tend to follow a trend.

---

In a MBS, whether a mortgage is called depends on the path of previous interest rates. If rates had been low previously, then mortgages are less likely to be called later on. Thus a binomial model that uses backward induction methodology (later outcomes are determined first) should not be used to value MBS.

cross-ied

Assume that interest rates in the year 2010 decrease below historical averages. They continue their downward trend for years 2011 and 2012. In which year would a MBS be least likely to be experience high rates of prepayment?

A) 2012.

B) 2013.

C) 2010.

---

In a mortgage-backed security (MBS), whether a mortgage is called depends on the path of previous interest rates. If rates have been on a downward trend, then fewer mortgages will be refinanced as the trend continues because homeowners that have wanted to refinance will have already done so. Thus fewer mortgages will be refinanced in the year 2012 than in the earlier years.

cross-ied

Prepayment burnout in a mortgage-backed security (MBS) refers to the fact that:

A) some tranches will experience extreme rates of prepayment.

B) in the later years of a downward trend in interest rates, fewer mortgages will be refinanced.

C) eventually a MBS will exceed the maximum prepayments allowed when interest rates drop too low.

---

In a MBS, whether a mortgage is called depends on the path of previous interest rates. If rates have been on a downward trend, then fewer mortgages will be refinanced as the trend continues because homeowners that have wanted to refinance will have already done so. Prepayment burnout means that eventually mortgage refinancing will slow in the later stages of a downward trend in interest rates.

LiquidAssets10

How is the option-adjusted spread (OAS) computed using the Monte Carlo simulation model? The OAS is the value of the spread that, when added to all of the simulated spot rates, makes the:

A) average of the present values from the simulated cash flow paths equal to the market price of the mortgage-backed security.

B) present value of cash flows equal to the market price of the mortgage-backed security.

C) theoretical present value, assuming a constant prepayment rate, equal to the market price of the mortgage-backed security.

---

The option adjusted spread for the Monte Carlo model is the spread that must be added to all of the spot rates along each interest rate path that will make the average present value of the path cash flows equal to the market price (plus accrued interest) for the MBSs being evaluated.

LiquidAssets10

If the simulated interest rates are based on the Treasury curve, then how is the option-adjusted spread obtained (OAS) using the Monte Carlo simulation model interpreted? The OAS is the:

A) spread over the Treasury spot rate corresponding to the maturity of the mortgage-backed security.

B) average spread over the Treasury yield.

C) average spread over the Treasury spot rate curve.

---

The monthly rates along the paths generated with the Monte Carlo simulation model using the Treasury yield curve as a benchmark are Treasury spot rates that have been adjusted to be arbitrage-free. As such, the OAS measures the average spread over Treasury spot rates, not the Treasury yield.

LiquidAssets10

The spread (k) that must be added to all of the spot rates along each interest rate path that will force equality between the average present value of the path’s cash flows and the market price (plus accrued interest) for the mortgage-backed security (MBS) being evaluated is called the:

A) PAC spread.

B) k-spread.

C) option-adjusted spread (OAS).

---

The spread (k) that must be added to all of the spot rates along each interest rate path that will force equality between the average present value of the path’s cash flows and the market price (plus accrued interest) for the MBS being evaluated is called the OAS.

LiquidAssets10

Wanda Brunner, CFA, is evaluating two tranches of a sequential-pay CMO structure.

Tranche	OAS (bps)	Z-spread (bps)	Effective duration
I	95	100	4.25
II	90	100	4.25

How should Brunner trade these CMO tranches?

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 pointsTranche 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 she should buy it.
• Tranche II is overvalued on a relative basis (“rich”), and she should sell it.

LiquidAssets10

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

A) small.

B) big.

C) zero.

---

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

LiquidAssets10

The major differences in effective duration among analytical systems providers are attributable to all of the following assumptions EXCEPT:

A) option adjusted spread (OAS) differences.

B) differences in changes in interest rates.

C) mortgage-rate differences.

---

Mortgage rate differences do not cause effective duration differences among analytical system providers.