Measuring the Effects of Prepayment Rates on Mortgage-Backed Securities

• Activity Number: 49
• Type: Contributed
• Date/Time: Sunday, August 11, 2002 : 4:00 PM to 5:50 PM
• Sponsor: Business & Economics Statistics Section*
• Author(s): Stephen Mansour*+
• Affiliation(s): The Carlisle Group, Inc.
• Keywords: Bonds ; Simulation ; Finance ; Random Variable ; Yield ; Matrix Algebra

Abstract

Mortgage-backed securities differ from corporate and government bonds in that their cash flows cannot be estimated with certainty, since homeowners often prepay their mortgages. Prepayments may include sale of the property, refinancing, curtailments, or liquidation of the property due to foreclosure.

Standard fixed-income measurements, which allow investors to compare different types of bonds, include price, yield, average life, duration and convexity. Exact bond measurements cannot be calculated for mortgage-backed securities because the underlying cash flows are dependent upon the prepayment rate, which is a random variable. However, prior information about the distribution of prepayment rates allows one to estimate a bond measurement by defining it as a function of the prepayment rate.

Simulating prepayment rates can provide information about the probable yield, average life, and other measurements of mortgage-backed securities. Computer implementation is not difficult because the calculations involve matrix algebra, which can easily be translated into an array-based programming language such as APL.