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A 3-factor Valuation Model for Mortgage-Backed Securities (MBS) TAKEAKI KARIYA FUMIAKI USHIYAMA Research Center for Financial Engineering Department of Social Informatics KIER, Kyoto University Kyoto University Sakyo-ku, Kyoto 606-8501 Japan Sakyo-ku, Kyoto 606-8501, Japan kariya@kier.kyoto-u.ac.jp ushiyama@kuis.kyoto-u.ac.jp and STANLEY R. PLISKA∗ Department of Finance University of Illinois at Chicago 601 S. Morgan Street, Chicago, IL 60607-7124 USA srpliska@uic.edu April 13, 2002 Abstract In this paper we generalize the one-factor MBS-pricing model pro- posed by Kariya and Kobayashi(2000) to a 3-factor model. We describe prepayment behavior due to refinancing and rising housing prices by incentive response functions. Our valuation of an MBS is based on discrete-time, no-arbitrage pricing theory, making an association be- tween prepayment behavior and cash flow patterns. The structure, ra- tionality, and potential for practical use of our model is demonstrated by valuing an MBS via Monte Carlo simulation and then conducting a comparative statics analysis. 1 Introduction Via a no-arbitrage pricing theory in a discrete time setting, Kariya and Kobayashi(2000) (abbreviated KK(2000) or simply KK below) formulated a framework for pricing an MBS (Mortgage-Backed Security) and proposed ∗Professor Pliska was a chair professor of Applied Financial Engineering sponsored by Nomura Securit