An investor is considering the purchase of either an IO or PO strip from a CMO offering. The portion of the mortgage pool backing this tranche consists of $1,000,000 in mortgages with a remaining of 10 years and an 8 percent interest rate.
a. Assuming annual payments and a zero prepayment rate, prepare a schedule showing the IO and PO cash flows that would be payable to investors in this tranche. If the interest rate demanded by investors on this investment is also 8 percent, what would be the prices of the IO and PO strips?
b. If interest rates increased to 10 percent and prepayments remained at a zero rate, how would the price of the IO and PO strips change? Which security, the IO or PO, exhibits the greatest price change from (a)? Why?
c. Investor interest rates now decline to 6 percent. What is the price of the IO? PO? Prepayments now increase to a rate of 20 percent per year because mortgage borrowers in the pool begin to refinance at lower interest rates. What would prices for the IO and PO be now? (Assume that the 20 percent prepayment received at the end of each year is based on the outstanding loan balances at the end of the preceding year.) Which security, the IO or PO, exhibits the greatest change in price when compared to (a) and (b) above? Why? What does this pattern suggest about the relative risk of each security?
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