The delivery option in mortgage backed security valuation simulations

A delivery option exists in mortgage backed security market, which has not been considered in existing mortgage pricing simulation literature. We explain the delivery option in the "to be announced" trade. We discuss how the presence of the delivery option effects the use of the standard pricing simulation technique. This technique uses a risk neutral interest rate simulation with a prepayment option model to recover a price which is an expectation over the possible rate outcomes. The simulation technique uses Monte Carlo integration with a suitable selected pseudo or quasirandom sequence. To recover market prices a spread term called the "option adjusted spread" is required. We see that multiple simulations are required to explore the full structure of the delivery option but suggest how to use one simulation to approximate pricing even when the delivery option is present.