A new multidimensional prepayment model introduced to the MBS market last week by Andrew Davidson & Co. may not only allow users to complement their existing prepayment model, but may also prove to be a valuable hedging tool.
The recently developed Implied Prepayment Model for Mortgage-Backed Securities computes the prepayment speeds implied by actual market valuations of TBAs and compares the results to the speeds forecasted by other models.
More importantly, the new model uses market prices to get its results, rather than making estimates based on historical prepayment performance, which has been the typical method by which a prepayment model functions.
Previous models contain "tuning factors," whereby the user adjusts conceptual features (aging factors, the steepness of the refi incentive curve, etc.) in order to duplicate a model that is more complicated; often 20 or 25 numbers are needed to calibrate to another model. With the Implied Prepayment model, however, the user does not have to fit prices based on market prices, but can automatically calibrate to another model.
The model extracts the predictions of future prepayment speeds imbedded in the current prices of liquid TBAs. Tuning parameters from other models can then be used to adjust the generic settings in order to reflect a gauge of market sentiment.
"With this new model, you can detect when market sentiment or expectations differ greatly from the model you're using," said Eknath Belbase, Ph.D., of Andrew Davidson, who developed the model. "In this way, it may be a good hedging tool, in that you are comparing the hedging effectiveness of a historical-based model versus the implied model. If someone else is using another prepayment model, it can help you understand that model in different way, giving clues as to how the market is viewing prepayments overall, as opposed to just basing it on one factor, such as PSA."