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Seminars

Where is the Option? Prepayment Modeling of MBS

Date: 04-30-2007
Start Time: 6:00pm
End Time: 7:30pm
Speaker: Andrew Kalotay, Andrew Kalotay Associates & Deane Yang, Polytechnic University
Location: 412 Schapiro CEPSR, Davis Auditorium

ABSTRACT

Traditional MBS prepayment models are based on historical prepayments. Although they are very good at explaining what happened in the past, their ability to explain market prices is another matter. The endless stream of “new and improved” prepayment models speaks for itself.

A noteworthy deficiency of traditional models is the absence of “mortgagor intelligence”. They cannot describe how market factors such as lower transaction costs or higher interest rate volatility would affect prepayment behavior.

We will present a true option-based model that employs option-adjusted spread (OAS) analysis to determine the optimal refinancing strategy. This optimum provides a convenient reference point to describe actual behavior.

The model is calibrated to the market prices of liquid fixed income securities. Empirical results indicate that it is remarkably robust and accurate. Since the model is amenable to recursive valuation, the speed of the application— 10,000 valuations per minute on a low-end PC — is unprecedented.

BIO

Andrew Kalotay, president of Andrew Kalotay Associates is a leading authority on corporate and municipal debt management. He has written widely on such topics as bond refunding, interest rate derivatives, and valuation of bonds with embedded options. His innovations include the concept of refunding efficiency—a widely used tool for managing callable debt—and the Ratchet Bond, a surrogate for conventional callable bonds.

Before founding AKA, Dr. Kalotay was with Salomon Brothers in the Bond Portfolio Analysis Group. Prior to that he was at AT&T Treasury and at Bell Laboratories.

On the academic side, he was the first director of the Center for Finance & Technology at Polytechnic University, and has taught at Wharton, Columbia and Fordham University. Apart from his academic publications, he currently writes the “Topics in Fixed Income” column in Financial Engineering News.

Dr. Kalotay holds a B.Sc. and M.Sc. from Queen's University and a Ph.D. from the University of Toronto, all in mathematics. In 1997 he was inducted into the Fixed Income Analyst Society’s "Hall of Fame"

Deane Yang is Director of Research at Andrew Kalotay Associates. He has worked with Andy Kalotay to develop new models for pricing induced options and mortgage-backed securities, as well as the VRM hedge effectiveness test for FAS 133. He has previously worked at Sumitomo Bank Capital Markets, where he worked on credit risk, VaR, and interest rate derivative pricing models.

Also Professor of Mathematics at Polytechnic University, he has also been a faculty member at the Courant Institute of Mathematical Sciences at New York University, Columbia University, and Rice University. He does research in differential geometry and convex geometric analysis.

Deane has a B.A. in Mathematics and Physics from the University of Pennsylvania and a Ph.D. in Mathematics from Harvard University.

PRESENTATION