Pure econometric approaches to pricing mortgage-backed securities (MBSs) -
principal pricing vehicles used by financial practitioners - fail to capture
their true risks. This point was powerfully driven home by the global
financial crisis. Since prior to the crisis default rates of MBSs were quite
modest, econometric pricing models systematically underestimated the
possibility of default. As a result, MBSs were severely overvalued. It is
widely believed that the global crisis was largely triggered by incorrect
valuation of mortgage-backed securities. In the aftermath, it is important to
revisit the foundations for pricing MBSs and to pay much closer attention to
default risk. This paper introduces a comprehensive model for valuation of
fixed-rate pass-through mortgagebacked securities in a simple option-based
framework. In the model, we use bivariate binomial tree approach to
simultaneously model prepayment and default options. Our simulation results
demonstrate that the proposed model has sufficient flexibility to capture the
two principal risks.
Jump Diffusion Models for Risky Debts: Quality Spread Differentials
