Analyzing Non-Agency RMBS: A Practical
Application of Option-Adjusted Returns

Abstract

Risky markets like non-agency RMBS require methods to determine risk-adjusted returns. Risk is properly defined as the volatility of potential returns, and options theory provides metrics to compare one bond investment with another. Credit option-adjusted spread (COAS) is determined from thorough simulation analysis of the underlying risks of future house price and interest rate movements and their impact on borrower behavior and thus bond cash flows. The usefulness of COAS is that Risk-Adjusted Return = Gross Yield – COAS. RAR is superior to other methods of investment volatility because RAR can be directly compared from one investment to another.