This paper considers the pricing of multiclass commercial mortgage-backed securities. A contingent-claims pricing methodology that overcomes state variable dimensionality problems is developed to examine mortgage pools with many distinct underlying assets and whose loan cash flow values are subject to interest rate uncertainty. Security structure and the correlation structure of collateralizing assets within a pool are found to be important determinants of tranche price and required yield spread. By disentangling default loss risk from default-related call risk, we show it is possible that mezzanine investment classes may require lower yield spreads than higher priority investment classes. Of particular interest is the finding that reduced cash flow volatility obtained through pool diversification may actually decrease the value of the first-loss (junior) tranche. When examining the relationship of pool size and tranche value, we find that five to 10 distinct mortgages are required to realize most of the effects of asset diversification.
|Number of pages||23|
|Journal||Journal of Financial and Quantitative Analysis|
|State||Published - Dec 1996|
Bibliographical noteFunding Information:
* Childs and Ott, Department of Finance, College of Business and Economics, University of Kentucky, Lexington, KY 40506-0034; Riddiough, Department of Urban Studies and Planning, Center for Real Estate. Massachusetts Institute of Technology, Cambridge, MA 02139-4307. The financial support of the Real Estate Research Institute is gratefully acknowledged. We are also grateful to Jim Follain, Mike Giliberto, Laura Quigg, Howard Thompson, to finance workshop participants at MIT and the University of North Carolina, to session participants at the 1995 AREUEA meetings, to participants at the 1996 Real Estate Research Institute conference, and to Jonathan Karpoff (the editor) and Eduardo Schwartz (the referee) for helpful comments. We alone are responsible for the contents and conclusions found in this paper. 'The residential MBS statistics are from Federal Reserve Board Reports—Mortgage Debt Outstanding.
ASJC Scopus subject areas
- Economics and Econometrics