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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:

  1. 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
  2. from a financial perspective, is this because the ZVOAS is higher to compensate for the increased prepayment risk
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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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