You work for a pension fund that wants to diversify its portfolio by investing in mortgage- backed securities. The fund has identified a potential deal, but it needs your help to model the cash flows, especially because the underwriters have chosen not to follow the typical PSA approach. The prospectus states that the deal coupon is 6.5%, the WAM is 360 months, and the loan stratification is provided in the following table:

Finally, the prospectus indicates that prepayments should be modeled using the PPC approach with the following ramp: 2-12% CPR over the first 25 months.

1. Use this information to prepare a monthly cash flow statement for your firm to understand what they can expect to earn if they invest in the entire security.

2. Using a money-weighted return calculation, what is your firms expected return on this investment?

After presenting these numbers to your colleagues, they have a brainstorming session where they float the idea of separating the MBS into a PO strip and an IO strip. They ask you to model how differently the investment would look if they purchased one of these strips.

3. Add two new columns to the cash flow statement: a PO strip cash flow and an IO strip cash flow. Calculate these two sets of cash flows for each month.

4. Using the money-weighted return calculation, what is your firms expected PO strip return and their expected IO strip return?

5. Why are these returns different? What different risks do they represent?

\begin{tabular}{|c|c|} \hline Net Note Rate & Balance in Cohort \\ \hline 4.382% & 1,200,000 \\ \hline 4.441% & 6,700,000 \\ \hline 4.810% & 13,000,000 \\ \hline 4.923% & 14,500,000 \\ \hline 5.011% & 19,000,000 \\ \hline 5.662% & 22,000,000 \\ \hline 5.717% & 22,500,000 \\ \hline 5.829% & 23,400,000 \\ \hline 5.999% & 20,100,000 \\ \hline 6.091% & 18,000,000 \\ \hline 6.226% & 16,500,000 \\ \hline 6.373% & 14,000,000 \\ \hline 6.498% & 11,900,000 \\ \hline 6.680% & 3,000,000 \\ \hline 6.705% & 1,500,000 \\ \hline \end{tabular}