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A three‐factor valuation model for mortgage‐backed securities (MBS)

Takeaki Kariya (Graduate School of Business, Meiji University, Tokyo, Japan)
Fumiaki Ushiyama (Fixed Income Research Department, Nomura Securities, Tokyo, Japan)
Stanley R. Pliska (Department of Finance, University of Illinois at Chicago, Chicago, Illinois, USA)

Managerial Finance

ISSN: 0307-4358

Article publication date: 27 September 2011

Abstract

Purpose

The purpose of this paper is to generalize the one‐factor mortgage‐backed securities (MBS)‐pricing model proposed by Kariya and Kobayashi to a three‐factor model. The authors describe prepayment behavior due to refinancing and rising housing prices by discrete‐time, no‐arbitrage pricing theory, making an association between prepayment behavior and cash flow patterns.

Design/methodology/approach

The structure, rationality and potential for practical use of our model is demonstrated by valuing an MBS via Monte Carlo simulation and then conducting a comparative static analysis.

Findings

The proposed model is found to be effective for analysing MBS cash flow patterns, making a decision for bond investments and risk management due to prepayment.

Originality/value

While the one‐factor valuation model Kariya and Kobayashi treated is a basic framework, the generalized model presented in this paper is much more effective for analysing MBS cash flow patterns, making a decision for bond investments and risk management due to prepayment.

Keywords

Citation

Kariya, T., Ushiyama, F. and Pliska, S.R. (2011), "A three‐factor valuation model for mortgage‐backed securities (MBS)", Managerial Finance, Vol. 37 No. 11, pp. 1068-1087. https://doi.org/10.1108/03074351111167947

Publisher

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Emerald Group Publishing Limited

Copyright © 2011, Emerald Group Publishing Limited