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

Explain the relationship between growth and inequality, While poverty reduc...

While poverty reduction has become the main goal of development efforts, there is an on-going and sometimes heated debate about the elements that would be at the center of any sens

Introduction to fixed income portfolio management strategies, Investors use...

Investors use two management strategies to manage their fixed income portfolios. They adopt either active management strategy or passive management strategy. A

What is deferred incomes, Q. What is Deferred Incomes? Deferred incomes...

Q. What is Deferred Incomes? Deferred incomes are incomes received in advance before supplying goods or services. They represent funds received by a firm for which it has to su

Define flowcharts - documenting the accounting system, Flowcharts - Documen...

Flowcharts - Documenting the accounting system Depict in outline the sequence of events in a system showing document flow and department or function responsible for every ev

#title Find the NPV of 2 Projects, Woody Construction is considering a new ...

Woody Construction is considering a new 3 year expansion project that requires an initial fixed asset investment

What is adjusted gross income, Q. What is Adjusted Gross Income? Adjust...

Q. What is Adjusted Gross Income? Adjusted Gross Income - Gross income decreased by business and other specified expenses ofindividual taxpayers. Amount of adjusted gross incom

Depreciation expense and investment in property plant, Use the excel spread...

Use the excel spreadsheet to project the net income for Winnebago from assumptions about key revenue & expense items.   Use the following assumptions to evaluate the projected net

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

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