question archive 1)Suppose we have a new type of MBS to accommodate the short-term investor
1)Suppose we have a new type of MBS to accommodate the short-term investor
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1)Suppose we have a new type of MBS to accommodate the short-term investor. This new MBS security instrument contains only 5-year mortgages (in reality are rare if non-existent). ACME, a private secondary mortgage market, has pooled together ten $100,000 5-year mortgage loans. Note:To save space in writing out your work, you can scale the ten $100,000 to $100. Calculate the duration for this MBS pool assuming annual compounding for three years at 10 percent interest which
a.is a "zero coupon".
b.is an interest-only MBS.
c.is fully amortizable over the five years.
2. Now assume that the interest-only MBS in problem 2b. is prepayable (but not defaultable). Use the option-theoretic model to price this MBS. Interest rates have a 50% chance of going up 1% each year and a 50% chance of going down 1% each year. From your results, qualitatively compare the MBS value without prepayment to the MBS value with prepayment. Note:To save space in writing out your work, you can scale the ten $100,000 to $100.
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Answer:
The MBS with a feature of prepayment has a risk that they can be prepaid, for that investor will demand extra return because they are bearing extra risk of prepayment.
There are 50% chance that the interest rate will be 11%, so the value of MBS is calculate by taking average of 10% interest rate mbs and 11% interest rate of MBS.
Mbs without prepayment allowed will have a same value because both upward 1% chance and downward 1% chance are 50% which means net expected change in interest rate is 0%.
So, the value will be same.
Ref:
https://www.investopedia.com/terms/p/prepaymentrisk.asp
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