Derivatives in Plain Words by Frederic Lau, with a ... - HKU Libraries

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12Mortgage-backed securities (MBS) are securities backed by mortgages. MBScan be privately issued or issued by quasi-government agencies. The mostliquid and active MBS market is in the US, where there are over US$1.2trillion worth of MBS outstanding (in 1992), and over US$300 billion of newMBS and mortgage loan pools issued each year.MORTGAGE PASS-THROUGH SECURITIESThe traditional MBS are "mortgage pass-through" securities in which thelender bank pools mortgage loans with similar characteristics together,collects principal and interest payments every month, and passes throughthe principal and interest payments less the servicing and other fees toinvestors. Investors receive pro rata shares of the resultant cash flows.Suppose an investor buys a pass-through MBS at par, backed by a pool ofmortgage loans all with 10 percent interest rate fixed for 30 years. (30-yearfixed rate mortgages are very common in the US.) Assume that interestrates drop by two percent after the purchase. A common misconception isthat the market value of the MBS would go up just like other bonds. Thisis not the case for MBS. When rates drop, borrowers tend to refinancetheir mortgages. Instead of paying 10 percent mortgages fixed for 30 years,they can now refinance their loans at 8 percent. This is pretty bad for theMBS investor. Instead of seeing his investment goes up in value because ofthe rate drop, he gets his investment paid off at par. In addition, he has toreinvest his money at lower rates now. This is the "prepayment risk" of MBS.On the other hand, if interest rates go up from 10 percent to 12 percent,borrowers would not rush to refinance their mortgages because they canenjoy paying lower rates (10 percent versus the market rate of 12 percent)Mortgage-backed Securities
for the remaining life of their mortgages. The investor, who was expecting toget some of his money back (the regular amortisations, and normal prepaymentsbased on an assumed prepayment speed) to invest at a higher rate, is notgetting back as much as he expected. And the original investment horizonbecomes longer now. This is the "extension risk" of MBS.PREPAYMENT CHARACTERISTICS OFThe most important characteristic of MBS is prepayment. Prepayment iswhen borrowers prepay their mortgages before the maturity date. Althoughinterest rate is the most important factor that influences prepayment pattern,prepayment always exists no matter how interest rates and other economicfactors change. People tend to prepay their mortgages for various reasons:moving up to a bigger and better house, or relocating to a different location,etc. In California, statistics show that people tend to move every 5 to 7years. For the whole nation, the average life is 7 years for 15-year mortgageloans and 12 years for 30-year loans. Therefore, when an investor investsin a 10 percent coupon MBS backed by a pool of 30-year loans, his investmenthorizon is not 30 years but more or less 12 years under a normal situation.The prepayment characteristic is so important that when a collateral mortgageobligation (CMO), a more complex form of MBS, is priced, the average lifeand the yield of the bond are quoted based on an assumed prepaymentspeed. There are two common methods for measuring prepayment speed:Conditional Prepayment Rate (CPR) method and Public Securities Association(PSA) method. CPR represents the annualised percentage of the outstandingbalance that is prepaid during the period. For example, 6 percent CPRmeans that 6 percent of the outstanding balance, net of scheduledamortisations, will be prepaid each year. PSA, on the other hand, assumesthat unseasoned loans tend to be prepaid at slower rates. The base PSA(100 percent PSA) assumes that prepayments rise linearly from 0.2 percentCPR to 6 percent CPR over 30 months from the origination of the mortgage,and then remain constant at 6 percent CPR. A ISO PSA means thatprepayment speed will rise to 9 percent (1.50 x 6 percent) over 30 monthsand then remain at 9 percent.Mortgage-backed Securities
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THE UNIVERSITY OF HONG KONGLIBRARIE
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VI- . .7 « i8^p ! ««^^OOSHSlVCJ
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Ever since derivatives took centre-
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denominator, value at risk, which c
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the kind of information that superv
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This book is a team effort of the H
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While most market participants defi
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of this investment is 6.32 percent
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Mathematically, the relation betwee
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$10,000. (For simplification of pre
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Hong Kong does go up and the HSI ri
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3OF ATHEPRICING OF A FORWARD CONTRA
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COST OF CARRYIn the above example,
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interest rate swap rates. From thes
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Borrowers, on the other hand, usual
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Page 36 and 37: 5In this chapter, we will discuss w
Page 38 and 39: often complain that there is too mu
Page 40 and 41: ABC also has three cash flows:1. It
Page 42 and 43: Assuming that there is no transacti
Page 44 and 45: simulation techniques and mathemati
Page 46 and 47: The calculation of credit risk proc
Page 48 and 49: The payments are exchanged every th
Page 50 and 51: the reference rate. When this type
Page 52 and 53: Effectively this is just a 2-year s
Page 54 and 55: This measure of duration is referre
Page 56 and 57: analysis, it also has its shortcomi
Page 58 and 59: Percentage change in price due to d
Page 60 and 61: 8OFOptions are generally perceived
Page 62 and 63: OPTION'S PAYOFF PATTERNWhat about a
Page 64 and 65: Volatility is the most important fa
Page 66 and 67: fANDTrading options becomes more po
Page 68 and 69: You need to hold 7 shares of stock
Page 70 and 71: di = [ln(IOO/IOO) + (0.06 + O.P/2)
Page 72 and 73: is10In the previous chapter, we dis
Page 74 and 75: stock will go up in the near future
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Page 78 and 79: OF AN11In the previous two chapters
Page 80 and 81: at-the-money option approaches its
Page 84 and 85: NEGATIVE CONVEXITYFor MBS, there is
Page 86 and 87: MULTI-CLASSIn 1983, Freddie Mac int
Page 88 and 89: 13What is a hedge? According to the
Page 90 and 91: management to enter into swap and o
Page 92 and 93: transaction. For this criterion to
Page 94 and 95: CREDIT DEFAULT SWAPThe simplest for
Page 96 and 97: APPLICATION OF CREDIT DERIVATIVESYo
Page 98 and 99: in the US. Equally innovative, cred
Page 100 and 101: THE VARIANCE-COVARIANCE METHODThe t
Page 102 and 103: "cell" would have a cash flow expos
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Page 120 and 121: The derivatives industry can be com
Page 122 and 123: ANDONOFINTRODUCTION1. The Monetary
Page 124 and 125: MANAGEMENT AND CORPORATE5. As the B
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RISK MEASUREMENT25. Having identifi
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) the tendency of the relevant mark
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38. The measurement of the market r
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market, credit and liquidity risk o
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Consideration must be given to the
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55. As noted earlier, the market or
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changes in portfolio value;d) the r
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66. A basic and essential safeguard
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73. It is essential that the intern
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Market liquidity risk is the risk t
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Furthermore, contracts with the sam
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There are three main VAR approaches
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Options risk should be captured; ri
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Annex D1. NOTIONAL OR VOLUME LIMITS
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assumptions on which they are based
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* There should be a unit independen
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- the customer had specifically req
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addition and deletion of operators,
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• Profits and losses resulting fr
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This book is due for return or rene
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