THE PRICING OF MULTICLASS COMMERCIAL MORTGAGE-BACKED SECURITIES

This paper considers the pricing of multiclass commercial mortgage-bac ked securities. A contingent-claims pricing methodology that overcomes state variable dimensionality problems is developed to examine mortga ge pools with many distinct underlying assets and whose loan cash how values are subject to interest rate uncertainty. Security structure an d the correlation structure of collateralizing assets within a pool ar e found to be important determinants of tranche price and required yie ld spread. By disentangling default loss risk from default-related cal l risk, we show it is possible that mezzanine investment classes may r equire 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 mortgag es are required to realize most of the effects of asset diversificatio n.