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

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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