A three-factor valuation model for mortgage-backed securities (MBS)

Purpose - The purpose of this paper is to generalize the one-factor mortgage-backed securities (MBS)-pricing model proposed by Kariya and Kobayashi to a three-factor model. The authors describe prepayment behavior due to refinancing and rising housing prices by discrete-time, no-arbitrage pricing theory, making an association between prepayment behavior and cash flow patterns. Design/methodology/approach - The structure, rationality and potential for practical use of our model is demonstrated by valuing an MBS via Monte Carlo simulation and then conducting a comparative static analysis. Findings - The proposed model is found to be effective for analysing MBS cash flow patterns, making a decision for bond investments and risk management due to prepayment. Originality/value - While the one-factor valuation model Kariya and Kobayashi treated is a basic framework, the generalized model presented in this paper is much more effective for analysing MBS cash flow patterns, making a decision for bond investments and risk management due to prepayment.