Open AccessOption-based valuation of mortgage-backed securities
Author(s) -
Ana Manola,
Branko Urošević
Publication year - 2010
Publication title -
economic annals/ekonomski anali
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.148
H-Index - 12
eISSN - 1820-7375
pISSN - 0013-3264
DOI - 10.2298/eka1086042m
Subject(s) - prepayment of loan , valuation (finance) , binomial options pricing model , economics , synthetic cdo , mortgage underwriting , valuation of options , actuarial science , financial crisis , financial economics , econometrics , credit risk , finance , mortgage insurance , credit valuation adjustment , casualty insurance , insurance policy , credit reference , macroeconomics
Pure econometric approaches to pricing mortgage-backed securities (MBSs) - principal pricing vehicles used by financial practitioners - fail to capture their true risks. This point was powerfully driven home by the global financial crisis. Since prior to the crisis default rates of MBSs were quite modest, econometric pricing models systematically underestimated the possibility of default. As a result, MBSs were severely overvalued. It is widely believed that the global crisis was largely triggered by incorrect valuation of mortgage-backed securities. In the aftermath, it is important to revisit the foundations for pricing MBSs and to pay much closer attention to default risk. This paper introduces a comprehensive model for valuation of fixed-rate pass-through mortgagebacked securities in a simple option-based framework. In the model, we use bivariate binomial tree approach to simultaneously model prepayment and default options. Our simulation results demonstrate that the proposed model has sufficient flexibility to capture the two principal risks