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(1)
where
a
pre-defined factor exposure,
(2)
(3)
(4)
In the above expressions,
, and
, ,
, and
is the change of i-
th key swap rate (i = 1 9 for 6M, 1Y, 2Y, 3Y, 5Y, 7Y, 10Y, 20Y, and 30Y tenors, respectively),
and
is their simple average; is the change in volatility in the period. is the change in
current coupon spread in the period. Each CMO bond, according to its collateral type, is
mapped to one of the three current coupon indexes: FNMA 30-year, GNMA 30-year, and FNMA
15-year. The key-rate durations, effective convexity, volatility duration, and current coupon
duration are generated using the Bloomberg mortgage prepayment model for each security
and at each time point.
Subtracting the above components from the stochastic return, we get the excess return, which
is to be modeled by implicit factors in the next step:
Bloomberg Fundamental Factor Models for SMBS and CMO
8
(5)
IMPLICIT FACTORS
The implicit factor model is presented as a multivariate linear equation, with pre-defined
factor loadings multiplied by factor returns to be determined in a multivariate regression
process. The dependent variable of the cross-sectional regression is the excess return divided
by spread duration, which measures the change of spread of the bonds. The level of the spread
of fixed-income products reflects additional premium an investor requires for taking on the
additional prepayment risk, liquidity risk, model risk, and other risks.
The Strip IO certificates are usually created based on a mega pool of Agency Fixed-rate pass-
through, of the same Agency, program (the majority are backed by FNMA or FHLMC 30-Year),
coupon, and a narrow range of WALA. Noting the fact that the overwhelming majority of
Stripped MBS are backed by conventional 30-year pools and the substantial similarity between
FNMA and FHLMC corresponding programs, we ignore Agency and program and construct the
implicit factors using price premium-ness and collateral WALA. The Bloomberg Strip IO spread
model has three price-WALA factors:
(6)
where
and
are the implicit factors, loadings, and the residuals, respectively. The
loading of each factor,
(7)
In use of the non-factor risk model, the non-factor risk of a Strip IO position can be estimate as:
(8)
0
0.2
0.4
0.6
0.8
1
1.2
0 6 12 18 24 30 36 42 48 54 60 66 72
W
A
L
A
F
a
c
t
o
r
s
WALA
New Seasoned
Bloomberg Fundamental Factor Models for SMBS and CMO
10
where the constant
comes from the ratio between the variance and square of expectation of
absolute value for a normal variable.
EXPLANATORY POWER
The explanatory power of Strip IO factors is demonstrated in Figure 5 using the 6 month
rolling average of adjusted r-squared. The blue line shows the effect of explicit factors (time
return, yield curve return, volatility return, and current coupon return), and the pink curve
demonstrates the joint effect of explicit and implicit factors of the Strip IO model. On average,
the explicit factors explained 10-30% of the variance of total return, while adding the implicit
spread factors improves this ratio to 20-60%.
Figure 6. Contribution of Factors to Explanatory Power of Strip IO model
BIAS TEST
The bias of a model is measured by the standard deviation of normalized portfolio returns,
(
) (9)
If the risk model forecasts the volatility of realized return properly, the expectation of this bias
statistic should be 1. In practice, we calculate this statistic for a rolling 10-month period, and
count what fraction of this quantity falls within its 95% confidence interval (
),
where T=10 is the rolling period. The Strip IO model is tested on numerous portfolios. As
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Aug-10 Feb-11 Sep-11 Mar-12 Oct-12 Apr-13 Nov-13
Explanatory Power of Strip IO Model
Explicit Factors + Implicit Factors
Bloomberg Fundamental Factor Models for SMBS and CMO
11
shown in Figure 7, on average, 75% of time the portfolios bias measure falls in this confidence
interval. This is satisfactory for a simple model of only three factors.
Figure 7. Percentage of time the risk estimate was within confidence interval.
PORTFOLIO RETURNS VS. FORECAST RISK
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
Agency Strip IO - Bias Test
Bloomberg Fundamental Factor Models for SMBS and CMO
12
Figure 8 compares the realized returns of market portfolio for Strip IO to model-predicted two
standard deviation bands. During the 22 months back-testing period, two realized returns fell
out of the band. This is a little higher than the expected (1 outlier out of 22), but still acceptable
for this simple model.
Bloomberg Fundamental Factor Models for SMBS and CMO
13
Figure 8. Realized Return vs. Predicted Risk.
STRIP PO AND AGENCY CMO MODEL
No new implicit factors are introduced for Strip PO and CMO bonds. Instead, we construct a
hedging portfolio for each Strip PO or CMO bond, using the corresponding Strip IO and MBS
Generic of its underlying collateral. The hedge ratios
(10)
where
, and
) (11)
Inserting the formulas for MBS (see Appendix I) and strip IO models into Eq. (11), and
incorporating the subscripts (for security) and (for time), we have the following expression for
CMO spread return:
-20
-15
-10
-5
0
5
10
15
Strip IO: Realized market portfolio return vs. 2 StDev band
Realized market portfolio return two standard deviation band
Bloomberg Fundamental Factor Models for SMBS and CMO
14
)
(12)
In the above equations, expressions for Strip PO are obtained by simply replacing subscript CMO
with PO. In this hedging strategy, PO securities are not simply treated as longing a unit amount of
collateral MBS and shorting a unit amount of the corresponding IO, as this simple hedge is only
accurate when two preconditions are satisfied: (a) the collateral of the trust is exactly the same as the
MBS generic; (b) the IO and PO are priced at their break-even OAS. These are usually untrue in
reality. However, a detailed look at the calculated hedge ratios reveals that for a PO, typically the
MBS hedging coefficients are scattering around 1 while the IO coefficients are close to -1.
For an example, see Appendix II.
NON-FACTOR RISK
The above analysis demonstrates that the residual return of PO and CMO is approximated by a linear
combination of the residual returns of hedging MBS and strip IO. Ignoring the correlation between
the residual returns of MBS and IO, we have
(13)
Therefore, the non-factor risk of CMO and PO are estimated by combining the MBS and Strip IO
non-factor risks.
BIAS TEST
Figure 9 shows the bias test results on various PO and CMO portfolios, including market
portfolios and spread duration quartile portfolios. On average, the model performs better on
PO portfolios than on CMO.
Bloomberg Fundamental Factor Models for SMBS and CMO
15
Figure 9. Percentage of time the risk estimate was within confidence interval.
PORTFOLIO RETURNS VS. FORECAST RISK
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
PO: market PO:
oasd.bot
PO:
oasd.top
PO:
oasd.mid
CMO:
market
CMO:
oasd.bot
CMO:
oasd.top
CMO:
oasd.mid
Agency Strip PO & CMO - Bias Test
Bloomberg Fundamental Factor Models for SMBS and CMO
16
Figure 10 compares the realized returns of market portfolios for Strip PO and CMO to their
model-predicted two times standard deviation bands, respectively. During the 22 months
period, one realized return for PO portfolio and 3 realized returns for CMO portfolio fell out of
the bands, respectively. Again, the model performs on PO portfolio better than on the CMO
portfolio.
Figure 10. Realized Return vs. Predicted Risk.
Summary
In this paper, we have presented the Bloomberg fundamental factor model for the US Agency
Strip MBS and CMO bonds. The model is carefully constructed by choosing intuitive factors and
using fully transparent statistical methodologies. The model passes bias testing with no
significant under- or over-forecasting of risk for a broad variety of portfolios.
-3
-2
-1
0
1
2
3
(a) Strip PO: Realized market portfolio return vs. 2 StDev
band
Realized market portfolio return two standard deviation band
-2
-1.5
-1
-0.5
0
0.5
1
1.5
2
(b) CMO: Realized market portfolio return vs. 2 StDev band
Realized market portfolio return two standard deviation band
Bloomberg Fundamental Factor Models for SMBS and CMO
17
Appendix I. A Short Summary of RMBS Risk Model
The Bloomberg RMBS fundamental factor model consists of 6 price-WALA factors (new-
premium, seasoned-premium, new-current, seasoned-current, new-discount, and seasoned-
discount) and 5 program factors (Conv15, Conv20, GNMA30, GNMA15, and IO):
(14)
For non-factor risk, we subsequently fit a model for the absolute value of residuals
(15)
where classifies each security into a certain MBS group, and
(16)
where the constant
comes from the ratio between the variance and square of expectation of
absolute value for a normal variable.
More details can be found in [2].
Appendix II. A Hedging Example
As an example, on April 1st, 2014, CMO Z-bond FNR 2003-32 ZT (CUSIP 31393BKU8) is
hedged by MBS Generic FNCL 6 2003 and Strip IO certificate FNS 344 2 (CUSIP 3136FCAB2).
On this date, we have the following data
FNR 2003-32 ZT FNCL 6 2003 FNS 344 2
price 111.651 111.146
16.680
OASD 4.729 4.078 2.692
ppayDur 0.035
0.043 0.452
Inserting the above values into Eq. (10), we have
and
. This means
we assume the risk characteristics of the Z-bond is approximated by a hedging portfolio
longing 1.188 times face value of MBS and shorting 0.237 times face value of Strip IO. On this
date, the underlying MBS is exposed to the RMBS Seasoned Premium factor, while the Strip IO
Bloomberg Fundamental Factor Models for SMBS and CMO
18
is exposed to the Strip IO Premium Seasoned factor. Putting these facts together, and calling
Eq. (12), we find that this CMO Z-bond is exposed to implicit risk factors as follows:
Exposure
RMBS USD: Seas Prem -4.825
Agency CMO: SIO Prem Seas
0.095
The signs of the exposures shown on PORT are flipped, as we do for all factor exposures
including yield curve.
References:
[1] Yingjin Gan and Luiza Miranyan, Fixed Income Fundamental Factor Model, February,
2012.
[2] Sunny Wei Zhao, Yingjin Gan, Luiza Miranyan, Hui Zhang, and Nick Baturin,
Fundamental Factor Model for Securitized Products, March, 2012.