Douglas Breeden
Duke University, Durham, NC 27708
ABSTRACT
This article examines the second-order effect of prepayments on mortgage risk. It focuses on brokers' forecasts of option costs for interest-only securities, but includes as well an analysis of conventional (whole) fixed-rate MBS. The empirical option costs for IOs turn out to fluctuate more widely than the median brokers' forecasts, indicating that investors would be well advised to put a band of error around their estimates of option-adjusted durations and option costs and benefits. The results for conventional MBS are similar, although with a great deal of annual fluctuation.