Katharina Richter, CFA, is a fixed-income analyst at Paar Advisors, an investment advisory firm. She is evaluating a set of mortgage-backed securities (MBS) so she can make recommendations about those securities for the firm’s clients.

The securities, which are not yet issued, will be backed by a pool that currently contains $117.54 million of U.S. 30-year residential mortgages. The pool has a weighted-average coupon (WAC) of 4.80% and a weighted-average maturity (WAM) of 243 months, which implies 17 months of seasoning, Richter reviews current prepayment estimates for this pool from three different providers. The first estimates a CPR of 8.5%, the second a prepayment speed of 220 PSA, and the third an SMM of 0.70%. As Richter reads about one provider’s prepayment expectations, she finds the following statement:”Although U.S. mortgage interest rates are very low relative to the historical average, rates have been this low or lower for a number of years. Further, the general state of the economy is very poor. These factors cause us to expect low prepayment rates for the coming months.” After some analysis, Richter realizes market conditions are such that these securities will not to be issued for another two months. She adjusted her analysis of the pool, using the SMM estimate of 0.70%, to reflect this delay.

One of Paar’s clients, Konrad Hartmann, is concerned that mortgage interest rates might rise by about 1% in the near future and remains at that higher level for the foreseeable future. He asks Richter which of the many types of CMO tranches and stripes mortgage-backed securities would perform best if his concerns are realized. Hartman is also interested in the characteristics of MBS. He tells Richter that he understands that MBS are considered Path-dependent securities for three reasons:

Reason 1: The influence of earlier prepayments on current cash flows.

Reason 2: The tendency of few mortgage borrowers to prepay early in the life of their mortgage.

Reason 3: The way the current prepayment rate reflects whether borrowers have already had an
opportunity to refinance at the current mortgage rate.

Hartman shows Richter some spread information he has received regarding three CMO tranches. This information is found in Exhibit 1, below. He tells Richter he would be happy to invest in any of these securities based on their other characteristics and asks which he should choose based solely on this information.Exhibit 1Spread ComparisonNominal SpreadZero Volatility SpreadOption-Adjusted Spread Security X2.12%1.67%0.00% Security Y3.18%1.30%-0.27% Security Z1.84%1.46%0.67%