Analyzing prepayments in residential mortgaged backed securities pools in housing finance sector: Investors perspective

This paper analyses variations and effects of prepayment risk associated with Residential Mortgage Backed Securities in India. It suggests a method Option Adjusted Spread (OAS) of finding a commensurate risk premium required by investors. Authors present an example to illustrate differential impact on investors in senior and subordinate instruments. The paper finds that the structural arrangements of securitization extend different risk exposures to different classes of investors. The pre-payment risk adversely affects the senior tranche but may be a boon for the subordinate tranche. The method of OAS for finding a suitable risk premium has been suggested. As opposed to previous studies on the subject, this paper outlines and quantifies varied impact of investors of different risk appetite. It also suggests that investment in either of the securities necessitates assessment of risk of pre-payment.