Kose John, Crocker Liu, R A Radhakrishnan
ABSTRACT
This paper does a valuation analysis of senior-subordinated structure
tranches backed by non-agency mortgages. The valuation is done using Monte
Carlo simulation and employs the CIR interest rate process in conjunction
with an empirical model estimated for non-agency mortgage prepayments and
defaults. The sensitivity of the value of tranches to a number of variables
are analyzed. We find that the interest rate process parameters significantly
affect prepayments and defaults but not the relative value of the senior
tranche. It is found that with the shifting of prepayments, the senior
trances does not dominated all the junior tranches at all interest rates.
The shifting of prepayments has the unintended effect of providing stability
to the junior tranches by making their cashflows less sensitive to prepayments.
Our main conclusion is that while the shifting of prepayments increases
protection from default to the senior tranche for a given level of subordination,
it has the unwanted effect of lowering its value through increased contraction
risk. The value loss should be taken into account in determining the optimum
level of subordination.
John: (212) 998-0337 kjohn@stern.nyu.edu
Liu: (212) 998-0353 cliu@stern.nyu.edu
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