Prices of Mortgage-Backed Securities are adversely affected by the right of homeowners to prepay their mortgages, especially when mortgage rates fall below what they are currently paying. The consequences of this prepayment option is to effectively put a cap on prices of MBSs similar to call provisions on regular coupon bonds. Suppose you purchase a $100,000 face value, 30-year MBS carrying a coupon of 4 percent.

1. What is your monthly cash flow from the security?

2. What is the remaining principal balance on the mortgage if the homeowner prepays the mortgage at the end of 1-year? 3-years? 8-years?

3. How much interest will you receive in the first twelve months? Principal?

4. Calculate the price of the MBS under the following yield/prepayment scenarios:

Yield Years Survived

2 percent 1-year

3 percent 3-year

4 percent 8-year

10 percent 30-year

5) What would be the prices of a $100,000 face value 4 %, 8-year Treasury bond for a yield to maturity of 2%, 3%, 4% and 10%? Comment on the different price behavior of the bond and the MBS