Compare mortgage cash flow with treasury coupon bearing

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Reference no: EM131085668

Mortgage markets have developed significantly since the early 1970s through the creation of secondary market instruments in the form of mortgage pass-throughs, collateralized mortgage obligations (CMOs), and REMICs. These collectively have been generally referred to as mortgage backed securities (MBS). In many ways, these instruments carry the characteristics of their underlying assets -- individual mortgages.

a. Why is the cash flow of a mortgage, or a MBS, uncertain in the sense that the investor in the mortgage has granted the borrower a call option to prepay the mortgage? Compare a mortgage cash flow with a Treasury coupon bearing bond paying interest semi-annually and a payment of principal at maturity.

b. What does this call option depend upon and why?

c. The cash flow for a mortgage pass-through typically is based on some prepayment speed benchmark. Why is the assumed prepayment speed necessary to price the MBS?

Reference no: EM131085668

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