A Practical Guide to Relative Value for Mortgages

Wesley Phoa, Ph.D.

This paper describes quantitative methods for assessing relative value within the agency-backed MBS sector. A prepayment model which generates accurate effective durations can be used to compute option-adjusted spreads. The OAS on an MBS may be regarded as the risk premium for risks that cannot be hedged with Treasuries, namely:

1. Volatility risk
2. Model valuation risk
3. Model duration risk
4. Spread risk
5. Liquidity risk
6. Funding risk

We show how to quantify these risks and their theoretical value in terms of OAS. This allows us to compare the attractiveness of different securities on a risk/return basis.

It is important to note that the analysis cannot rely solely on historically derived volatilities or standard errors, but must be based on an informed judgment about future uncertainty. This is where detailed prepayment research can contribute to the analysis.

The paper shows how to carry out MBS relative value analysis in a detailed example, using risk measures computed by BondEdge.