Bank of America issues a MBS security based on a mortgage pool with the following terms:
Mortgage pool value $25,000,000
Mortgage interest rate 6.5%
Loan Term 3 years
a) Suppose that the MBS has only one class of security, i.e., the basic MBS discussed during the class. What is the price of this MBS if the market interest rate is 5.75%? Assume annual compounding as well as a constant annual prepayment rate of 10% (based on the outstanding loan amount at the beginning of each year, the same as the case we discussed during the class).
Now, another investment bank suggests that, instead of creating the single-class MBS security as above, two classes of securities can be created based on the same mortgage pool, i.e., an IO and a PO security.
b) Determine the price of the IO and PO security, assuming that there is no prepayment. Further assume that the IO investors require a market rate of return of 4.5% and the PO investors require a market return of 6%.
c) Now suppose future interest rates will fall, so there is a 10% prepayment for each year (prepayment calculation is based on the loan balance at the beginning of the year). The IO and PO investors require a market rate of return of 4% and 5.5%, respectively. Determine the prices of the IO and the PO security.
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