Abstract
This paper extends the framework of tranche size in fixed rate mortgage and the corresponding risk. We examine whether the tranche size changes with different underlying mortgages by adding the adjustable rate mortgage. With the method of analyzing the mortgage portfolio risk elaborated by Yang et al. (2009), we form an equal-weighted portfolio with two mortgage-backed securities and observe whether the diversification benefit caused by different correlations between the two house price appreciations shows on the tranche size. Based on the empirical findings, Senior tranche size of adjustable rate mortgage is thinner and the supporting level is thicker because of high default risk. With the internal rate of return, we demonstrate the rule of “high risk, high return; low risk, low return” by NR tranche size with the highest return and Senior tranche size with the lowest return among all tranche sizes. Diversification benefit caused by different correlations shows on Senior tranche size and its’ supporting level. We demonstrate the rule of “adding two assets which are not perfect positive correlated would lower the risk” by the increase of Senior tranche size and the decrease of its’ supporting level with the correlation declines.