19 - Mortgage-Backed Bonds II

Abstract

This chapter describes the position and risk implications that are associated with running a portfolio of mortgage securities. The chapter also describes the issues concerned with tracking an index. Mortgage-backed bonds present slight difficulty in their valuation because of the uncertain nature of their cash flow stream as well as the option feature that is attached to them. The prepayment rate for a mortgage-backed bond and the cash flows are path dependent. Interest-rate models simulate a set of randomly generated interest-rate paths that carry an element of uncertainty as to their accuracy. The market uses several valuation methods to generate scenarios of returns achieved during a specific holding period. The scenarios are usually generated using a simulation model such as the Monte Carlo simulation. For shorter time period horizons, the price distribution is very sensitive to the number of simulations that reflects the value of the embedded prepayment option. As the bond approaches maturity, the average price of the bond approaches par that is similar to the “pull-to-par” effect on a conventional plain vanilla bond.