Q2. (For this question, it is advisable to use Excel spreadsheet for the computation. You can verify your spreadsheet model by using it to replicate Table 8.3 in the text.)

Consider the following MBS pass through with principal $300 million. The original mortgage pool has a WAM = 360 months (30 years) and a WAC = 7.00%. The pass through security pays a coupon equal to 6.5%. Assume a flat term structure of interest rates of 6% (continuously compounded).

(a) What is the price of the pass through? Assume a constant PSA = 150%.

(b) Compute the duration of this security assuming that the PSA remains constant at 150%.

(c) Compute the effective duration of this security assuming that the PSA increases to 200% if the term structure shifts down by 50 basis points, while it decreases to 120% if the term structure shifts up by 50 basis points. Comment on any difference compared to your result in part (b).

(d) Compute the effective convexity of this security under the same PSA assumptions as in part (c). Interpret your results.