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Implement critical reforms that will produce a stronger and more resilient housing finance system.
FOSTER competitive, liquid, efficient, and resilient (CLEAR) national housing finance markets that support sustainable homeownership and affordable rental housing; OPERATE in a safe and sound manner appropriate for entities in conservatorship; and PREPARE for eventual exits from the conservatorships.
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Alexander Bogin, Senior Economist; Nataliya Polkovnichenko, Senior Economist; William Doerner, Senior Economist
Assessments of market risk for economic or regulatory capital typically involve calculating a portfolio’s sensitivity to key risk factor movements. Historically, practitioners have focused on two classical sources of risk, adverse changes in interest rates and volatility. As stress testing has evolved, additional risk factors have been identified, including several specific to fixed-income securities with embedded optionality. These include changes in prepayment rates or any of several other market risk factors, which affect option-adjusted spreads (OAS). We describe an empirical framework for generating shocks to prepayment rates and mortgage security OAS, which are consistent with simultaneous movements in other key risk factors, including the term structure of interest rates and implied volatility. Our prepayment rate shocks capture model misspecification and are calculated using historical performance data from multiple vendor prepayment models. These shocks are well defined, but capture only a portion of prepayment model error. Mortgage security OAS serves as a broader measure of model error, which encompasses both, model misspecification and forecasting errors as well as credit and liquidity risk. Our OAS shocks are calculated using historical six-month changes in spreads derived from multiple vendor quotes.
A revised version of this paper has undergone external peer-review and is published in an academic journal with open (free) access. Citation: Alexander N. Bogin, Nataliya Polkovnichenko, William M. Doerner. 2016. "Overlooked Market Risk Shocks: Prepayment Uncertainty and Option-Adjusted Spreads." Journal of Fixed Income, 26(2), 5-15. https://jfi.pm-research.com/content/26/2/5
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