Dynamic Analysis

Jason Vinar

U of MN

Spring 2010
The Hull-White (One-Factor) Model∗

Provides an exact fit to the initial term structure

dr = [θ(t) − ar ]dt + σdz

where a and σ are constants. It can be characterized as the Ho-Lee

model with mean reversion rate a. Can also be characterized as the
Vasicek model with a time-dependent reversion level. At time t, the short
rate reverts to θ(t)/a at rate a.

The function θ(t) is derived from the initial term structure:

dF (0, t) σ2
θ(t) = + aF (0, t) + (1 − e −2at )
dt 2a
where F (0, t) is the initial forward curve.

∗ Options, Futures, and Other Derivatives; John Hull; 7th Edition; p. 688-9
Bond Prices using the Hull-White Model∗
At time t bond prices are given by

P(t, T ) = A(t, T )e −B(t,T )r (t)

where
1 − e −a(T −t)
B(t, T ) =
a
and
P(0, T ) 1
ln A(t, T ) = ln + B(t, T )F (0, t) − 3 σ 2 (e −aT − e −at )2 (e 2at − 1)
P(0, t) 4a

Note, the last function explicitly incorporates the initial term structure
with the inclusion of P(0, t), P(0, T ), and F (0, t). These equations will
be used to calculate zero rates.

For the simulation code, you will want to use monthly periods to
represent time.

∗ Options, Futures, and Other Derivatives; John Hull; 7th Edition; p. 688-9
Simulating the Short Rate using Hull-White∗

The discrete version of the model is

√
∆r = [θ(t) − ar ]∆t + σZ ∆t

where Z ∼ N(0, 1).

Using recursive notation it is written as

√
rt+1 = rt + [θ(t) − art ]∆t + σZ ∆t

∗ Short rate simulation using Hull-White Model; Shing Hing Man

Simulating the Short Rate using Hull-White∗

The starting point of our simulation is the values for the parameters a
and σ and the function θ(t) which represents the initial term structure in
terms of forward rates. We first covert the initial zero coupon curve R(t)
to forward rates F (0, t).

Recall that
dR(t)
F (0, t) = R(t) + t
dt
which can be approximated by

R(t) − R(t − ∆t)

F (0, t) ≈ R(t) + t
∆t

∗ Short rate simulation using Hull-White Model; Shing Hing Man

Simulating the Short Rate using Hull-White∗
To simplify the simulation process, rewrite
√
rt+1 = rt + θ(t)∆t − art ∆t + σZ ∆t

We will use ∆t = 1/12

Simulation Steps:
1. Interpolate the monthly zero rates, R, from the initial term
structure, Y
2. Approximate the forward rates, F
3. Set t = 0 and r0 to the overnight interest rate
4. Pick a random number from a standard normal distribution
5. Approximate θ(t)∆t using

σ2
θ(t)∆t ≈ F (0, t + ∆t) − F (0, t) + aF (0, t)∆t + (1 − e −2at )∆t
2a
6. Compute rt+1
7. Repeat steps 4, 5, and 6 for as long as needed
∗ Short rate simulation using Hull-White Model; Shing Hing Man
Adding MBS Prepayments to the Simulation
Our prepayment model is a function of the refinance incentive, age, and
the pool factor. Using the prepayment model along with the pass
through security characteristics produces the simulated monthly principal
and interest payments.
We will expand the short rate simulation to include each of these
elements
◮ The refinance incentive is a function of the 10-year treasury yield
◮ Age is increased by 1 for each step of the simulation
◮ Pass through cash flows (payment, interest, servicing and guarantee
fee, an d principal (scheduled and unscheduled) are calculated
◮ Pool factor is updated to incorporate the principal pay down

Recall the prepayment model functional form

ˆ k (RIk , AGEk , PFk ; θ) =
SMM
 
AGEk
PFk min , 1 (θ1 + θ2 arctan(θ3 + θ4 RIk ))
θ5
Adding MBS Prepayments to the Simulation

Refinance Incentive
Recall, RI = f (C , M) where C is the WAC and M is the 10-year treasury
yield. Using the simulated short rate the long rate in continuous
compounding is
ln P(t, t + T )
Mc = −
T
where T = 10. Now converting to BEY we have
c
/2
M BEY = 2(e M − 1)

Suppose the month in the simulation is 360, then the 10-year zero
coupon bond price is P(360, 360 + 120). Note that the discount factor
for the 480th month is needed.
Adding MBS Prepayments to the Simulation

Age
The age is just advanced by 1 month throughout the simulation.

Pool Factor
The pool factor is defined by the percent of the original pass through
balance that remains at the beginning of the month. Therefore, PFk is
known from the Pk−1s u
, Pk−1 , and Bk−1 before SMMˆ k is computed which
leads to deriving PFk+1 that is used in the next step. A couple useful
relationships are
Bk
PFk =
B0
and s u
Bk−1 − Pk−1 − Pk−1
PFk =
B0
Adding MBS Prepayments to the Simulation

SMM, Single Month Mortality

Make sure that all of your dynamic variables change as the monthly
process ticks by. It is also important to make sure the dynamic variables
(age and pool factor) are reset when each new simulation/path begins.

Pass Through Cash Flows

Calculate the principal and interest payments given estimated SMM.
These are the same calculations used in the pass through cash flow
program. Recall that this starts with finding the monthly mortgage
payment, then the interest, the servicing and guarantee fee, the
scheduled principal payment, and lastly the unscheduled principal
payment given the prepayment assumption.
Simulation Inputs
Global Assumptions
◮ Time Step, ∆t = 1/12

◮ Number of Simulations or Paths N

Hull-White Model
◮ Initial Yield Curve, often times quoted in BEY so convert to
continuous compounding and interpolate each monthly point
◮ a, the mean reversion speed and σ, the interest rate volatility
MBS, Pass Through Details
◮ Current Balance (FACE) and pool factor; implies the original balance
◮ PTR, pass through rate or coupon
◮ WAC, weighted average mortgage coupon or interest rate
◮ WAM, weighted average maturity
◮ WALA, weighted average loan age
Prepayment Model
◮ Functional Form and Model Parameters
Simulation Outputs
Each output is a matrix with each row representing a simulation
(i = 1 . . . N) and each column representing a month (j = 1 . . . WAM) or
vice versa.
◮ Short Rate SR(i, j), will be used later in OAS calculation
◮ Long Rate LR(i, j), i.e. the 10-year Treasury rate in BEY used to
project prepayments
◮ Interest Payments IP(i, j), used in IO and/or CMO structures
◮ Principal Payments PP(i, j), used in PO and/or CMO structures
◮ Other Rates needed in the calculation of a floater and inverse floater
structure. Often times the index rate is the one-month rate so the
short rate will do.
◮ Optional items which can be helpful in debugging
◮ Prepayment Projection SMM(i, j)
◮ Balance BAL(i, j)
◮ Monthly mortgage loan payment X (i, j)
◮ Servicing and Guarantee Fee S(i, j)
Preliminary Calculations and Functions
These are yield curve related calculations and occur sequentially
1. Create a time vector (in years) and a corresponding month vector (in
periods)
2. Convert the input yield curve to continuous compounding and
interpolate all the monthly points
3. Optionally, adjust the yield curve up or down for purposes of
calculating duration and convexity
4. Compute the monthly discount factors
5. Compute the forward rates

There are a couple functions you will need

◮ The zero coupon bond price function P(t, T ) and supporting
functions B(t, T ) and A(t, T ). You may want to code these in terms
of months as the time dimension instead of years, e.g. P(m, M)
◮ The prepayment model that produces SMM given θ, RI , AGE and
PF . As a simplification to the simulation the prepayment model
uses RI as a one month lag instead of 2.
Pseudo Simulation Code

Inputs
Preliminary Calcs
For (i = 1 . . . N)
For (j = 1 . . . WAM)
if (j = 1)
SR(i, j) = 1-month rate of the cont. comp.
LR(i, j) = 10-year rate of the cont. comp.
BAL(i, j) = current balance or face amount
else
SR(i, j) = f (SR(i, j − 1))
LR(i, j) = f (SR(i, j))
BAL(i, j) = f (BAL(i, j − 1), PP(i, j − 1))
end
Calculate SMM(i, j), X (i, j), IP(i, j), S(i, j), and PP(i, j)
Next j
Next i
Outputs
Option Adjusted Spread∗
Overview
◮ Extends scenario analysis to a large number of scenarios instead of a
select few
◮ Aims to understand the relative value and risk of a security by
considering the average performance over several scenarios
◮ The weakness of OAS is compressing all the scenario information
into a single number. It tends to hide the richness of the analysis
from the user.
The Progression of Spread
◮ The first is the static yield spread where the MBS yield is compared
to the Treasury yield at the same WAL
◮ Next, is the z-spread which is an improvement since it considers
multiple points on the yield curve
◮ The forward spread came next which incorporated the forward yield
curve in prepayment projections
◮ The OAS extends the forward spread by including interest rate
volatility with the forward yield curve
∗ Securitization, Structuring and Investment Analysis; Davidson, et. al.
Spreads by Example∗

GNMA 6% MBS using a 371% PSA prepayment assumption with a price

of 102.78
◮ Static Spread, the MBS yield in 5.20% with a WAL of 4.16 which
leads to a static spread of 203 basis points
◮ Z-Spread, solving for sZ in
WAM
X CFk
PRICE =
(1 + (Zk + sZ )/12)k
k=1

gives z-spread of 135 bps. This also sometimes called the zero
volatility spread.
◮ Forward Z-Spread, using the forward curve to project prepayments
(at a lower PSA of 200) and cash flow leads to a forward z-spread of
106 basis points. This is the arbitrage-free, zero volatility spread.

∗ Securitization, Structuring and Investment Analysis; Davidson, et. al.

Spreads by Example∗

GNMA 6% MBS using a 371% PSA prepayment assumption with a price

of 102.78
◮ Option Adjusted Spread, the OAS is the spread added to the
discount rates needed to match the price of the security when the
borrower’s call option is included in terms of the interest rate
volatility. It is the average additional return that MBS provides
relative to the simulated yield curve. The OAS is 22.

Method Static Z-Spread Forward OAS

Spread 203 135 103 22
Difference 68 32 81

The option cost is difference between the z-spread and the OAS, 113 in
this example. It can also be thought of as the cost to hedge the options
in perfect markets. It is naive to think you will earn the static spread
without hedging the yield curve and prepayment risks.

∗ Securitization, Structuring and Investment Analysis; Davidson, et. al.

Calculating the Option Adjusted Spread∗

OAS is a combination of path wise valuation concepts and the spread

over the yield curve. The OAS is found using an iterative method that
produces the market price.
N WAM
1 XX CFi ,j
PRICE = Qj
N k=1 (1 + ri ,k + OAS)
i =1 j=1

where N is the number of path simulations, CFi ,j is the cash flow for
simulation i and month j, and ri ,k is the one period discount rate for
period simulation i and period k.

The cash flow CFi ,j can be the monthly cash flow from a pass through,
an IO, a PO, or any structured CMO. Computing the OAS for a CMO
requires the additional step of running the pass through cash flows
through the CMO structure.

∗ Securitization, Structuring and Investment Analysis; Davidson, et. al.

TBA Spread Time Series
FNMA TBA Spreads
250

200

150

100

50

Zero Vol Spread

OAS
−50
2000 2002 2004 2006 2008 2010 2012
Recent OAS in the Market

Pass through securities and trust strips

TBA 2008 PT 2008 PO 2008 IO
12 12 -50 200

Sequential CMO Bonds

2 Year 4 Year 7 Year
-50 -50 -14

PAC CMO Bonds

2.5 Year 4 Year 6 Year 8 Year 11 Year 17 Year
-40 -40 -11 6 11 21
Revisiting Effective Duration and Convexity using OAS
We can now use our simulation to find the effective duration and
convexity of our MBS security.

Assuming we have prepayment model that produces price reasonably

close market prices we can use our simulation to produce the prices for
the base yield curve and up/down parallel shifts of the yield curve at the
market OAS.

Example
PTR = 4.0, WAC = 4.60, WAM = 360, WALA = 0, and OAS = 0.002.
The base price P = 95.80.
With ∆y = 0.0025, P−∆y = 96.91 and P∆y = 94.60.

P−∆y − P∆y
ED = = 4.82
2P∆y
P−∆y + P∆y − 2P
EC = = −1.50
100P(∆y )2
Market Implied Prepayment Model∗

Given a set of MBS prices and OAS and yield curve the market implied
prepayment model produces the market prices. This is achieved by
adding adjustment factor(s) to the prepayment model. In addition to
hedging and valuation benefits the time series of adjustment factors can
provide a guage to market sentiment.

The OAS is usually calculated by generating a set interest rate paths

consistent with the yield curve, computing the prepayments given the
interest rate simulation, and using the simulated short rates plus a spread
(the OAS) to discount the cash flows.

In this analysis, instead of computing the OAS we will be changing the

prepayment model via the factor(s) until we get the market OAS at the
market price.

∗ An Implied Prepayment Model for MBS, Quantitative Perspectives; Eknath

Belbase
Market Implied Prepayment Model∗
We begin by adding one global adjustment factor λ to the prepayment
model

SMMk (RIk , AGEk , PFk ; θ, λ) =

 
AGEk
λPFk min , 1 (θ1 + θ2 arctan(θ3 + θ4 RIk ))
θ5

This can be extended by adding multiple factors though it is typically

done by two factors. The first, β1 slides the s-curve left and right. The
second, β2 speeds up and slows down the responsiveness of borrowers to
the refinance incentive.

SMMk (RIk , AGEk , PFk ; θ, β) =

 
AGEk
PFk min , 1 (θ1 + θ2 arctan(θ3 β1 + θ2 β2 RIk ))
θ5

Note, all the factors are multiplicative, i.e. when they are equal to 1 we
have the unadjusted prepayment model. Combinations and additions to
these two forms can also be used.
∗ An Implied Prepayment Model for MBS, Quantitative Perspectives; Eknath
Belbase
Market Implied Prepayment Model∗

◮ It is important to remember that adding the tuning factors is not

intended to provide a better forecasting model. Rather it is used to
understand the relative risk in market pricing.
◮ This concept can be extended to other risk measures in MBS such
as effective duration and effective convexity.
◮ Another useful application is in comparing two prepayment models
and the respective factors needed for each to achieve market pricing.

∗ An Implied Prepayment Model for MBS, Quantitative Perspectives; Eknath

Belbase