Problem 1: Mortgage Risk

Your hedge fund owns an MBS pool backed by fully amortizing fixed rate mortgages with a coupon interest rate of 4.5%, and a remaining maturity of 26 years. Based on your analysis of past prepayment data, you currently expect all the mortgages in the pool to prepay fully in five years time. The market interest rate (used for discounting future cash flows) is 3%. Mortgage payments are monthly, as usual. Note #1: you should be able to answer all the questions below using your financial calculator, and it is probably a good idea to do so, to make sure you know how to use your calculator properly. However, feel free to use Excel if you prefer, or as a check on your answers. Note #2: When expressing the price of the pool in part A, express your answer as a percentage of par value, and report your answer rounding to the nearest 32nd of a basis point. This is the normal way that MBS prices are reported. For example: if a pool with par value of $10m is trading at $10.15m (a premium of 1.5%), its price would be reported as 101-16, meaning 101 plus 16/32).

A. What is the market price of the pool described above, expressed as a percentage of par value?

B. Imagine that Quickens new Rocket Mortgage app becomes widely available to borrowers and sends alerts to them continuously prodding/reminding or nudging them to refinance. As a result, 10% of the borrowers in the pool refinance their mortgages via Quicken immediately, and the other 90% are now expected to prepay their mortgages in three years time instead of five years time. What gain or loss will your hedge fund experience, expressed as a percentage of the prior market value of your MBS investments?

C. What kind of risk does the scenario in part B illustrate (among the four types of risks we

discussed in the third week of class)? Briefly explain the economic intuition for why your fund

experienced a gain or loss in part B.

D. Go back to the original information in the question (ignoring part B and C). Imagine that market interest rates suddenly rise from 3% to 5%. What gain or loss will your hedge fund experience, expressed as a percentage of the original market value of your mortgage investment, assuming that borrower prepayment behavior does not change?

E. Imagine that your hedge fund was leveraged 8 to 1 (i.e. only one-eighth of the assets are

financed by equity). What would be the effect of the scenario in part D on the market value of

the equity in your hedge fund?

F. What kind of risk does the scenario in part D illustrate (among the risks we discussed in the third week of class)?

G. In practice, if the interest rate shock in part D occurred, what would you expect to happen to borrower prepayment behavior? Would this change in behavior be good news or bad news for you as an MBS investor? (No calculations required, but please explain the economic intuition).

H. Describe a scenario where liquidity risk might cause a change in value in your investment. (You just need to explain / sketch a potential scenario in words, no numbers required). Would the liquidity risk of your investment likely be higher if this was an agency MBS pool, or a nonagency MBS pool? Briefly explain your logic.