Cash flows from mortgage- backed security, Financial Management

Assignment Help:

It is a well known fact that the value of a financial claim reflects the present value of the cash flows produced by the financial claim. While valuing an MBS an important thing to be decided upon is with regard to the cash flows, given the nature of the underlying mortgage contracts.

To an MBS investor, cash flows comprises three components,

CFt   =   NIt + SPt + PRt

Where,

CFt   =   total cash flow to investor.

NIt    =     monthly interest payment net of servicing and other fees.

SPt   =   scheduled principal payment for month t.

PRt   =   forecasted unscheduled principal repayments in month t (prepayments).

The significant amount is the prepayment PRt, which occurs at the discretion of the borrowers.

The following table shows the mechanics of a classical pass through MBS.

Table 

Payments of mortgage borrower: PRt + SPt + It

Repayments: PRt + SPt

(Gross) Interest coupon payments: It = i MBt-1

Forecasted unscheduled prepayment: PRt

Monthly scheduled payment of borrowers
(coupon plus amortization on mortgage balance)

 

                   MPt = MBt-1  2064_cash from mortgage security.png

 

Prepayments

PRt = SMMt (MBt-1) - SPt)

Scheduled repayments

 

SPt = MPt - It

Interest net of service fees

 

NLt = MBt-1 (i - s)

Service fee (going to servicer)

 

St = s MBt-1

Cash flow to MBS investors: CFt = PRt + SPt + It - St = PRt + SPt + NIt

 

Where,

It        =   Gross interest coupon payments

MBt     =   Mortgage balance

MPt     =   Monthly scheduled payment of borrowers

SMMt   =     Standard monthly mortality rate, i.e. prepayment rate, which can also be modelled using more sophisticated econometric techniques

St       =     Servicing fee.

Based on the mortgage balance from the previous month, the above process is repeated.

The link between the months follows the dynamic stock adjustment equation

MBt - MBt-1 = PRt + SPt

Through this equation, the events of one period affect the cash flows of all consequent periods. This is also called path-dependency. Undoubtedly, if it was not for the uncertainty of the prepayments, PRt, the process would be perfectly predictable on the basis of knowledge of i, s, n, and MB0.


Related Discussions:- Cash flows from mortgage- backed security

ANY, need to understand some basics of changes in working capital

need to understand some basics of changes in working capital

Characteristics of warrants, Characteristics of Warrants As mentioned e...

Characteristics of Warrants As mentioned earlier, a warrant is a variant of a call option and gives the holder a certain right to purchase shares of the company at a predetermi

Determine the limitations of trade receivable day ratio, Determine the Limi...

Determine the Limitations of trade receivable day's ratio Year-end trade receivables may not be representative of the year. Credit sales are VAT exclusive in the Incom

What are three major sections of the statement of cash flow, What are the t...

What are the three major sections of the statement of cash flows? Cash flows from financing activities Cash flows from investing activities Cash flows from Operations

Describe historical cost and future costs, Q. Describe Historical cost and ...

Q. Describe Historical cost and future costs? Historical cost and future costs: another problem in the determine of cost of the capital arise on the accounts of the difference

Market-based versus bank-based financial systems, What do you meant by mark...

What do you meant by market-based and bank-based financial systems? Market-based versus bank-based financial systems implications. The presence of market-based and bank-base

What is traded investments, Traded investments The term traded investme...

Traded investments The term traded investment refers to the buy of an investment asset which is traded in the financial markets. Instance includes government and ordinary share

Shareholders versus managers, Shareholders versus Managers A Limited Li...

Shareholders versus Managers A Limited Liability company is possessed by the shareholders though in most of the cases is managed by a board of directors selected by the shareho

International bonds, International bonds are divided into two c...

International bonds are divided into two categories namely, foreign bonds and euro bonds. Foreign bonds are issued by a borrowing company in another

What is the irr of the project, QUESTION Part A: 1. Nev Plc is consi...

QUESTION Part A: 1. Nev Plc is considering to invest in a machine to manufacture a new line of umbrellas. The following data has been assembled in respect of the investment:

Write Your Message!

Captcha
Free Assignment Quote

Assured A++ Grade

Get guaranteed satisfaction & time on delivery in every assignment order you paid with us! We ensure premium quality solution document along with free turntin report!

All rights reserved! Copyrights ©2019-2020 ExpertsMind IT Educational Pvt Ltd