level of difficulty rises with the complexity of the IR model and the sophistication of the prepayment IR dependence, to the point that no closed-form solution (i.e., one that could be written down) is widely known. In models of this type, numerical methods provide approximate theoretical prices. These are also required in most models that specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use specialised Monte Carlo methods or modified Binomial Tree numerical solutions. Interest rate risk and prepayment risk Theoretical pricing models must take into account the link between interest rates and loan prepayment speed. Mortgage prepayments are usually made because a home is sold or because the homeowner is refinancing to a new mortgage, presumably with a lower rate or shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they receive the money, because it tends to occur when floating rates drop and the fixed income of the bond would be more valuable (negative convexity). In other words, the proceeds received would need to be reinvested at a lower interest rate. Hence the term prepayment risk. Professional investors generally use arbitrage-pricing models to value MBS. These models deploy interest rate scenarios consistent with the current yield curve as drivers of the econometric prepayment models that models homeowner behavior as a function of projected mortgage rates. Given the market price, the model produces an option-adjusted spread, a valuation metric that takes into account the risks inherent in these complex securities. There are other drivers of the prepayment function (or prepayment risk), independent of the interest rate, such as: economic growth, which is correlated with increased turnover in the housing market home prices inflation unemployment regulatory risk (if borrowing requirements or tax laws in a country change this can change the market profoundly) demographic trends, and a shifting risk aversion profile, which can make fixed rate mortgages relatively more or less attractive Credit risk The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high because: Most mortgage originations include research on the mortgage borrower's ability to repay, and will try to lend only to the creditworthy. An important exception to this is "no-doc" or "low-doc" loans. Some MBS issuers, such as Fannie Mae, Freddie Mac, and