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The Pricing of Multiclass Commercial Mortgage-Backed Securities

Published online by Cambridge University Press:  09 June 2010

Paul D. Childs ,
Steven H. Ott  and
Timothy J. Riddiough
Paul D. Childs
Affiliation:
Department of Finance, College of Business and Economics, University of Kentucky, Lexington, KY 40506-0034
Steven H. Ott
Affiliation:
Department of Finance, College of Business and Economics, University of Kentucky, Lexington, KY 40506-0034
Timothy J. Riddiough
Affiliation:
Department of Urban Studies and Planning, Center for Real Estate, Massachusetts Institute of Technology, Cambridge, MA 02139-4307.
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Abstract

This paper considers the pricing of multiclass commercial mortgage-backed securities. A contingent-claims pricing methodology that overcomes state variable dimensionality problems is developed to examine mortgage pools with many distinct underlying assets and whose loan cash flow values are subject to interest rate uncertainty. Security structure and the correlation structure of collateralizing assets within a pool are found to be important determinants of tranche price and required yield spread. By disentangling default loss risk from default-related call risk, we show it is possible that mezzanine investment classes may require lower yield spreads than higher priority investment classes. Of particular interest is the finding that reduced cash flow volatility obtained through pool diversification may actually decrease the value of the first-loss (junior) tranche. When examining the relationship of pool size and tranche value, we find that five to 10 distinct mortgages are required to realize most of the effects of asset diversification.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 31 , Issue 4 , December 1996 , pp. 581 - 603
Copyright
Copyright © School of Business Administration, University of Washington 1996

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