there are two approaches to value

Question

There are two approaches to value Asset-Backed Securities. They are:

1. Zero-Volatility Spread (Z-spread) Approach.

2. Option-Adjusted Spread (OAS) Approach.

The Z-spread approach uses the spot interest rate plus zero-volatility spread to discount the cash flows and arrive at the value of Asset-Backed Securities. This approach does not consider the prepayment option. Therefore, it is suitable for characteristic a type of Asset-Backed Securities. Characteristic b type of Asset-Backed Securities also could be valued using Z-spread approach. Though the borrower in this type of Asset-Backed Securities has an option of prepayment he does not want to utilize it. Therefore, this makes the Z-spread equal to OAS. Characteristic c type of Asset-Backed Securities is valued using OAS approach. We can either use binomial model or the Monte-Carlo simulation model. Like mortgage-backed securities, even in asset-backed securities with prepayment option, the cash flow is interest rate path dependent. Therefore, the Monte-Carlo simulation model is used.