Effect of Prepayment and Call Limit on the Duration of CMO (Multi-tranche MBS): Full vs. Partial Pass-Through Structure

Abstract

Residential mortgage loans as well as the MBS (mortgage-backed security), which securitizes these loans, are exposed to prepayment risk. We examine the effect of prepayment process on the duration of the CMO (multi-tranche MBS). In particular, we examine the effect of partial pass-through where there is a call limit expressed as a percentage of initial tranche balance. Due to the absence of empirical research on the CMO duration, neither the actual CMO duration nor the determinants of the CMO duration have been reported. Our study reports the actual CMO duration and the determinants of the CMO duration. By showing that the CMO duration is much shorter than the nominal time-to-maturity we point to the need to search for longer duration MBS structures. We find that in both the deterministic and stochastic interest rate environments duration is reduced as prepayment speed rises and duration rises as call limit decreases.

We make contribution to the literature by shedding light on the effect of prepayment and call limit on the duration of multi-tranche MBS. In particular, this research characterizes the impact of the partial pass-through structuring approach on the CMO duration as well as CMO pricing. Finally, it assists CMO investors in better assessing and managing reinvestment risks of pass-through products.

Citation

Park, Y.W. and Bang, D.W. (2012), "Effect of Prepayment and Call Limit on the Duration of CMO (Multi-tranche MBS): Full vs. Partial Pass-Through Structure", Journal of Derivatives and Quantitative Studies: 선물연구, Vol. 20 No. 4, pp. 391-425. https://doi.org/10.1108/JDQS-04-2012-B0002