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Table of Contents
Foreword iii
Acknowledgments v
Introduction ix
Preface xix
Part I Valuation of Fixed Income Securities 1
Chapter 1 The Time Value of Money 3
1.1 Present Value 4
1.2 Future Value 5
1.3 Present Value of an Annuity 6
1.4 Future Value of an Annuity 7
1.5 Solving Financial Questions with Present and Future Value 8
1.6 Application to Fixed Income Securities 9
Chapter 2 Theories of the Term Structure of Interest Rates 11
2.1 The Rational or Pure Expectations Hypothesis 13
2.2 The Market Segmentation Theory 17
2.3 The Liquidity Preference Theory 17
2.4 Modeling the Term Structure of Interest Rates 19
2.5 Application of Spot and Forward Rates 21
Chapter 3 Fixed Income Metrics 27
3.1 Maturity 28
3.2 Yield to Maturity 28
3.3 Weighted Average Life 34
3.4 Duration 36
3.4.1 Macaulay Duration 37
3.4.2 Modified Duration 39
3.5 Convexity 42
3.6 Fisher-Weil Duration and Convexity 45
3.7 Effective Duration 51
3.8 Effective Convexity 53
3.9 Summing the Aforementioned Measures of Duration and Convexity 54
3.10 Key Rate Duration 55
Chapter 4 The Valuation of Fixed Income Securities 59
4.1 A Valuation Framework for Fixed Income Securities 60
4.2 Application of the Framework to Structured Securities 61
4.3 Twist and Shift: Characterizing Changes in the Level, Steepness, and Curvature of the Term Structure 63
4.4 Case Study: 4.00% 30-year MBS 65
4.5 Scenario Comparative Analysis 74
Chapter 5 Fixed Income Return Analysis 77
5.1 Return Strategies 78
5.2 The Components of Return 80
5.3 The Buy and Hold Strategy 80
5.4 Total and Absolute Returns 83
5.5 Deconstructing the Fixed Income Return Profile 84
5.6 Estimating Bond Returns with Price and Risk Measures 86
Part II Residential Mortgage Backed Securities 89
Chapter 6 Understanding Mortgage Lending and Loans 91
6.1 Classification of Real Estate 92
6.2 Residential Mortgage Loan Amortization 100
6.3 Deconstructing the Amortization Table 103
6.4 Mortgage Servicing 104
Chapter 7 Modeling Cash Flows 107
7.1 Prepayment Conventions 108
7.2 Modeling MBS Cash Flows 111
7.2.1 0% PPC Assumption - No Prepayment 112
Chapter 8 Mortgage Prepayment Analysis 117
8.1 Big Data - What is it? 118
8.2 The Statistical Learner 118
8.3 Survival Analysis 120
8.4 The Cox Proportional Hazards Model 125
8.5 Data Types 127
8.6 Case Study: FHLMC 30-yr Loan Level Prepayment Analysis 128
8.7 Survival Analysis - Modeling Loan Cohorts 139
Chapter 9 The Predictive Prepayment Model 145
9.1 Turnover 147
9.2 Loan Seasoning 147
9.3 Seasonality 149
9.4 Borrower Incentive to Refinance 150
9.5 Borrower Burnout 153
9.6 Application of the Prepayment Model 162
Part III Valuation of Mortgage Backed Securities 167
Chapter 10 Mortgage Dollar Roll 169
10.1 Evaluating the Dollar Roll 171
10.2 Risk Associated with the Dollar Roll 179
Chapter 11 Relative Value Analysis 183
11.1 Liquidity 184
11.2 Static Cash Flow Analysis 185
11.3 Return Analysis 189
Chapter 12 Option Adjusted Spread Analysis 197
12.1 Numerical Methods of Modern Financial Theory 199
12.2 Cox, Ingersoll, Ross Theory of the Term Structure 201
12.3 Calibrating the Model 206
12.4 Building the Option Adjusted Spread (OAS) Model 208
12.5 OAS Analysis as a Decision Making Tool 216
12.6 OAS Distribution Analysis 219
12.7 OAS Analysis Strengths and Limitations 225
Part IV Structuring Mortgage Backed Securities 227
Chapter 13 Introduction to REMICs 229
13.1 Background and Legal Structure 230
13.2 Two Tiered REMICs 234
13.3 REMIC Arbitrage 235
13.4 Bond Lab MBS Structuring Model 237
Chapter 14 Stripped Mortgage Backed Securities 239
14.1 Key Rate Duration Analysis 243
14.2 Option Adjusted Spread Analysis 245
14.3 The Information Content of the IO-PO Market 249
Chapter 15 Sequentially Structured REMIC 255
15.1 Key Rate Duration Analysis 259
15.2 Option Adjusted Spread Analysis 261
15.3 Weighted Average Life and Spot Spread Analysis 261
15.4 Static Cash Flow Analysis 266
Chapter 16 Planned Amortization Class (PAC) and Companion REMICs 269
16.1 The PAC Bond Sinking Fund Schedule 270
16.2 Key Rate Duration Analysis 277
16.3 Option Adjusted Spread Analysis 279
16.4 OAS Distribution Analysis 280
16.5 A Final Word Regarding PAC Bands 284
16.6 Static Cash Flow Analysis 285
Chapter 17 Sequential IO REMIC 287
17.1 Key Rate Duration Analysis 290
17.2 OAS Distribution Analysis 292
Chapter 18 PAC-Floater-Inverse Floater REMIC 295
18.1 Structuring the Floater and Inverse Floater 296
18.2 A Framework for Floating Rate Securities 301
18.3 Option Adjusted Spread Analysis 304
18.4 Key Rate Duration Analysis 304
Chapter 19 Accrual REMIC Z-bond 311
19.1 Key Rate Duration Analysis 317
19.2 Option Adjusted Spread Analysis 318
Part V Mortgage Credit Analysis 323
Chapter 20 Mortgage Default Modeling 325
20.1 Case Study FHLMC 30-year Default Analysis 327
20.2 Other Variables Influencing Borrower Default 335
20.3 Spread at Origination (SATO) and Default 340
20.4 Default Model Selection 340
Chapter 21 The Predictive Default Model 345
21.1 Constant Default Rate 347
21.2 Borrower Original Loan to Value Default Multiplier 348
21.3 Updated Loan to Value Default Multiplier 349
21.4 Spread at Origination (SATO) Default Multipliers 351
21.5 Completing the Prepayment Model 353
Chapter 22 The Basics of Private Label MBS 357
22.3 Y Structure 359
22.4 Shifting Interest 362
22.5 Deep Mortgage Insurance MI 363
22.6 Excess Interest 365
22.7 Overcollateralization 366
22.8 Structural Credit Protection 366
22.9 Hedging Asset/Liability Mismatches 369
Chapter 23 Sizing Mortgage Credit Enhancement 373
23.1 Simulating Borrower Default Rates 375
23.2 Estimation of Cumulative Default Rates 375
23.3 Translating Credit Enhancement to a Third Party Guarantee Fee 378
23.4 Role of the Credit Rating Agencies (NRSROs) 379
Chapter 24 Index 383
