Measuring prepayment uncertainty – a different approach

An alternative way of looking at prepayment uncertainty is to consider the effect of a
change in prepayment speed estimates on the effective duration of a mortgage or
portfolio of mortgage-backed securities. Since many firms hedge their mortgage
positions by shorting Treasuries with similar durations, it is important to note that
that the duration of a mortgage portfolio is uncertain and can be something of a
moving target.
These tables show the impact of a ô10% change in prepayment speeds on the
average life, effective duration and convexity of different types of mortgage collateral.
We can see that a small change in prepayment expectations could significantly change the computed interest rate sensitivity of a portfolio of mortgage-backed
securities. For example, a 10% change in our prepayment forecast for 30-year, 7.0%
collateral changes our effective duration (i.e. our estimated interest rate risk) by an
average of 9.37% (across new, moderately seasoned and fully seasoned pools with a
coupon rate, net WAC, of 7.0%). Since a small change in prepayment speeds can
cause us to revise our estimated duration by close to 10% (or more), this means that
an assessment of an MBS portfolio’s interest rate risk is clearly uncertain.
With these two approaches to measuring prepayment uncertainty, i.e. the change
in price or change in effective duration given a change in prepayment forecasts, a
risk manager can monitor the portfolio’s sensitivity to prepayment model risk in
terms of both market value and/or the portfolio’s interest rate sensitivity. For
example, the ‘change in market value’ form of prepayment uncertainty might be used
to adjust the results of a VAR calculation, while the ‘change in effective duration’
version could be used to analyze a hedging strategy to understand how a hedge
against interest rate risk for a position in MBS would have to be adjusted if
prepayment expectations shifted. The prepayment uncertainty measures presented
here can also assist with trading decisions on a single-security basis, as differences
in prepayment uncertainty may explain why two securities with seemingly very
similar characteristics trade at different OASs.