Implied prepayments - Addressing anomalies in modeling MBS value and risk.

Valuation of mortgage-backed securities using option-theoretic methods presents some puzzles. First, the option-adjusted spreads of pass-throughs are significantly larger than the spreads of agency debt, even though they are comparable credits. Second, the option-adjusted spreads of interest-only and principal-only strips are typically very different from those of the pass-throughs they are created from. Such results are inconsistent with the no-arbitrage principles that underlie the valuation model. The author argues that these puzzles arise from failure to account properly for the market's pricing of risk due to unpredictable changes in prepayments unrelated to interest rate changes. The author also demonstrates that it is possible to construct a prepayment model inferred purely from market prices of mortgage-backed securities, which, when used in a standard valuation model, automatically takes account of the market price of prepayment risk.