A three‐factor valuation model for mortgage‐backed securities (MBS)

Abstract

Purpose The purpose of this paper is to generalize the one‐factor mortgage‐backed securities (MBS)‐pricing model proposed by Kariya and Kobayashi to a three‐factor model. The authors describe prepayment behavior due to refinancing and rising housing prices by discrete‐time, no‐arbitrage pricing theory, making an association between prepayment behavior and cash flow patterns. Design/methodology/approach The structure, rationality and potential for practical use of our model is demonstrated by valuing an MBS via Monte Carlo simulation and then conducting a comparative static analysis. Findings The proposed model is found to be effective for analysing MBS cash flow patterns, making a decision for bond investments and risk management due to prepayment. Originality/value While the one‐factor valuation model Kariya and Kobayashi treated is a basic framework, the generalized model presented in this paper is much more effective for analysing MBS cash flow patterns, making a decision for bond investments and risk management due to prepayment.

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