Goldman Sachs claims proprietary leap in MBS options pricing

Goldman Sachs claims it has developed a revolutionary new model for pricing mortgage-backed securities (MBS). Alan Brazil, head of mortgage, ABS and rates research at Goldman Sachs in New York, said the new valuation model enables the increasing correlation between mortgage-backed securities and other fixed-income markets to be factored into options prices.

Previously, Goldman’s pricing model was typical of those used by investment banks, and was based on a projection of MBS from a prepayment model, formulated from analysis of historical data.

Goldman began developing a new interest rate term model two years ago. The model incorporates an updated prepayment model, as well as other models, which are designed to capture the interaction of mortgage valuations with other fixed-income markets in an arbitrage-free manner.

Brazil said the new model accommodates the multiple factors that determine MBS options prices, and therefore emphasises the direct, but diverse, response of mortgage obligors to rate incentives and to the ageing of the loans.

The new market-sensitive models are calibrated to swap rates instead of treasury yields – as was used in the earlier methodology. It also incorporates the various volatilities of swaptions with differing expiries, tenors and strikes.

“We believe it was well worth the effort,” said Brazil of the prolonged – and expensive – research and development. The team, headed by Jeremy Primer, Goldman's head of mortgage modelling, comprised four quantitative financial mathematicians, and has closed a “missing hole” in mortgage pricing mathematical technology, according to Brazil.

“There were short cuts we could have taken to get to about 90% of the accuracy we have subsequently achieved,” said Brazil. “But we think that extra 10% of accuracy will reap significant rewards in terms of being able to manage and price MBS risk in the future.”