Additional Market Risk Shocks: Prepayment Uncertainty and Option-Adjusted Spreads

Alexander Bogin, Nataliya Polkovnichenko () and William Doerner

No 15-03, FHFA Staff Working Papers from Federal Housing Finance Agency

Abstract: 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.

Keywords: prepayment; option-adjusted spreads; financial stress testing; capital standards; mortgage; risk management (search for similar items in EconPapers)
Pages: 24 pages
Date: 2015-07
New Economics Papers: this item is included in nep-net and nep-rmg
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Published in Journal of Fixed Income, 2016, volume 26, number 2, pages 5-15

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Persistent link: https://EconPapers.repec.org/RePEc:hfa:wpaper:15-03

DOI: 10.3905/jfi.2016.26.2.005

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