Abstract
We develop an integrated simulation/optimization model for managing portfolios of mortgage-backed securities. The mortgage portfolio problem is viewed in the same spirit of models used for the management of portfolios of equities. That is, it trades off rates of return with a suitable measure of risk. In this respect we employ amean-absolute deviation model which is consistent with the asymmetric distribution of returns of mortgage securities and derivative products. We develop a simulation procedure to compute holding period returns of the mortgage securities under a range of interest rate scenarios. The simulation explicitly takes into account the stylized facts of mortgage securities: the propensity of homeowners to prepay their mortgages, and theoption adjusted premia associated with these securities. Details of both the simulation and optimization models are presented. The model is then applied to the funding of a typical insurance liability stream, and it is shown to generate superior results than the standardportfolio immunization approach.
Similar content being viewed by others
References
D.F. Babbel and S.A. Zenios, Pitfalls in the analysis of option-adjusted spreads, Fin. Anal. J. (July/August 1992) 65–69.
W.W. Bartlett,Mortgage-Backed Securities: Products, Analysis and Trading (New York Institute of Finance, 1989).
F. Black, E. Derman and W. Toy, A one-factor model of interest rates and its application to treasury bond options, Fin. Anal. J. (Jan./Feb. 1990) 33–39.
J. Cox, J. Ingersoll and S. Ross, A theory of the term structure of interest rates, Econometrica 53 (1985) 385–407.
H. Dahl, A. Meeraus and S.A. Zenios, Some financial optimization models: I. Risk management, in:Financial Optimization, ed. S.A. Zenios (Cambridge University Press, 1992) pp. 3–36.
R.R. Grauer and N.H. Hakansson, Returns on levered actively managed long-run portfolios of stocks, bonds and bills, Fin. Anal. J. (Sept. 1985) 24–43.
M. Holmer, The FNMA asset/liability management system, Interfaces (1993), to appear.
P. Kang and S.A. Zenios, Complete prepayment models for mortgage-backed securities, Manag. Sci. 38 (1992) 1665–1685.
H. Konno and H. Yamazaki, Mean-absolute deviation portfolio optimization model and its applications to Tokyo stock market, Manag. Sci. 37 (1991) 519–531.
H. Markowitz,Portfolio Selection, Efficiency Diversification of Investments, Cowles Foundation Monograph 16 (Yale University Press, 1959; 2nd ed., Basil Blackwell, Cambridge, 1991).
J.M. Mulvey and S.A. Zenios, Capturing the correlations of fixed-income instruments, Manag. Sci., to appear.
E.S. Schwartz and W.N. Torous, Prepayment and the valuation of mortgage backed securities, J. Fin. 44 (1989) 375–392.
W.F. Sharpe, Mean-absolute-deviation characteristic lines for securities and portfolios, Manag. Sci. 18 (1971) B-1–B-13.
K.J. Worzel, C.V. Zenios and S.A. Zenios, Integrated simulation and optimization models for tracking fixed-income indices, Oper. Res., to appear.
S.A. Zenios and R.A. McKendall, Computing price scenarios of mortgage-backed securities using massively parallel computing, in:Modeling Reality and Personal Modeling, ed. R. Flavell (Springer, 1993) pp. 374–407.
Author information
Authors and Affiliations
Rights and permissions
About this article
Cite this article
Zenios, S.A., Kang, P. Mean-absolute deviation portfolio optimization for mortgage-backed securities. Ann Oper Res 45, 433–450 (1993). https://doi.org/10.1007/BF02282062
Issue Date:
DOI: https://doi.org/10.1007/BF02282062