During the first part of 2004, Freddie Mac's retained portfolio purchases were low due to tight mortgage-to-debt
option-adjusted spreads. Together with high liquidations, this has caused a net decrease in the retained portfolio.
Using the CRA adjusted model, we can then compare CRA nominal and
option-adjusted spreads to other sectors in the mortgage and asset-backed markets.
Treasury-based hedges should be used more when option-adjusted spreads (OASs) on mortgages are high.
Far more precise results could be obtained by using state-of-the-art option-adjusted spread models, which have been widely favored by sophisticated money managers for several years.
An option-adjusted spread model is needed to accurately determine price elasticity relationships, over a broad range of interest rate scenarios, between different mortgage types(and coupons) so as to enable the construction of accurate consolidated exposure reports.
Option-adjusted spread models should be used to derive hedge ratios.
Mortgage values under each scenario are then computed by taking the present value of the mortgage payments, using a discount rate equal to the compounded series of short-term Treasury rates simulated in that scenario plus an "option-adjusted spread" that represents the best "fit" to the most recent mortgage prices observable (Jacob et al., 1988).
[5] In addition, the price-process model does not require the use of an arbitrary option-adjusted spread to make model values of callable securities fit market price data (Ho, 1997).
Because the simulation model requires an estimate of an option-adjusted spread, the first observation (for the first quarter of 1984) is used to estimate the spreads that fit the simulation model values to the GNMA prices at that time.
