Explanation:
C is correct. When determining the OAS provided by the MBS, the process is:
A is incorrect. When conducting the Monte Carlo simulation after making an initial estimate of the OAS, the rate used is the Treasury rate plus the initial estimate of the OAS.
B is incorrect. Rather than just immediately purchasing a high-MBS pool, the analyst should investigate technical or institutional reasons for this outlying pool. There could be an assumption in the model that needs to be examined and potentially challenged.
D is incorrect. Mortgage rates are not perfectly correlated with Treasury rates and so even if an analyst has a perfect pre-payment model that depends only on interest rates, there will always be some residual interest rate risk when Treasury instruments are used as hedges. OAS = Expected MBS Return − Return on Treasury Instruments.
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Q-64. A financial analyst at a large investment firm is evaluating and selecting MBS pools to invest in. The analyst uses a Monte Carlo simulation to value the MBS pools and to determine the option-adjusted spread (OAS) for each of the pools being examined. Which of the following statements regarding OAS and MBS valuation techniques is most appropriate?
A
The OAS valuation procedure involves making an initial estimate of the OAS, followed by conducting a Monte Carlo simulation using the yield on US Treasury bills as the discount rate.
B
When an MBS pool with a high OAS is identified, it should be purchased immediately to take advantage of this relatively attractive investment compared to other MBS.
C
The OAS valuation procedure involves continually changing the OAS estimate until the simulated price is the same as the market price.
D
Mortgage rates are perfectly correlated with US Treasury bond rates, and therefore OAS is calculated as the expected MBS return plus the return on US Treasury bonds.
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