What assumption is made about the OAS in calculating the effective duration and effective convexity of a RMBS?
What will be an ideal response?
There is a problem with calculating price sensitivity measures such as interest-rate and prepayment sensitivity using the OAS methodology. Recall that in measuring effective duration and effective convexity, the calculation assumed that the OAS is held constant and the interest-rate paths are shifted by a specified number of basis points. After adding the initial OAS to the new interest-rate paths, a security is then revalued to obtain the two values to be used in the effective duration and convexity formulas. The trouble inassuming a constant OAS in calculating interest-rate sensitivity measures is that the assumption cannot be justified on theoretical grounds.
Thus, we have a serious problem with the notion of keeping OAS constant for measuring price sensitivity to changes to all sensitivity measures (e.g., interest-rate and prepayment sensitivity). One conclusion that can be drawn from this is to adjust (and use) a prepayment model so that it equates OAS levels.
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