How Prepayment Assumptions Affect MBS Z-Spread OAS

Summary

The document discusses whether a higher zero-volatility option-adjusted spread (ZVOAS) from one model indicates that it assumes faster mortgage prepayments than another. Its answer cautions that the spread alone cannot establish the prepayment assumption. For a given interest-rate path and prepayment model, ZVOAS reflects both the bond’s price relative to its cash flows and the shape of those cash flows, including whether the security passes through principal or separates interest and principal payments.

The response distinguishes ZVOAS from option-adjusted spread (OAS): because mortgage prepayments respond to the path of interest rates, practitioners generally prefer OAS, which accounts for multiple interest-rate paths. It also frames prepayment risk around how much prepayment behavior changes as rates move, rather than treating fast or slow prepayments as inherently favorable or unfavorable. The discussion is conceptual and offers no numerical example or procedure for comparing models; conclusions require controlling for price, cash-flow structure, rate paths, and other assumptions.

Key ideas

• A higher ZVOAS alone does not show that a model assumes faster prepayments.
• ZVOAS depends on bond price and cash-flow structure under a specified rate path and prepayment assumption.
• OAS is generally more informative for MBS because prepayments vary with interest-rate paths.
• Prepayment volatility as rates change can matter more for risk than the speed of prepayments by itself.

Tags

# Relationship between prepayments and ZVOAS in MBS


# Relationship between prepayments and ZVOAS in MBS












If two models are producing ZVOAS for the same MBS, I'm trying to understand, all things the same, which one is projecting a higher prepayment rate. For example, would Model 1 be projecting a higher prepayment rate as it is resulting in a higher ZVOAS than Model 2?

If so:

- mathematically, is this because a larger amount of cashflows are now associated with earlier periods, which would require a higher discounting factor to keep the price the same and

- from a financial perspective, is this because the ZVOAS is higher to compensate for the increased prepayment risk

## Answer by Sharad (score 1)

https://quant.stackexchange.com/a/68981

This doesn't answer your question directly but here are some slogans that you may find helpful:

- Because of the dependence of MBS prepayment rates on the path of interest rates, practitioners rarely look at ZVOAS and focus instead on OAS; ZVOAS is focused on a single path of interest rates, typically one in which rates evolve according to forwards

- On any given path of interest rates and a given set of prepayment assumptions, the ZVOAS will depend on both the price of the bond (discount/premium) and the cash flow pattern (pass-through, interest-only, principal-only etc)

- Fast or slow prepayments are not intrinsically good/bad, what matters most from the risk perspective is the volatility of prepayments as interest rates change

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This summary was written by Stratmill's research agent from the original; it is not a copy of the source.