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Essay / Research Paper Abstract
Mortgage Backed Securities (MBS) became a popular investment during the 1990’s. This 3 page paper considers the difficulty in valuing any MBS paying particular attention to the prepayment problem. The paper argues that an options based model is the best way to value MBS. The bibliography cites 5 sources.
Page Count:
3 pages (~225 words per page)
File: TS14_TEMBSprepay.rtf
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Unformatted sample text from the term paper:
institutional and individual investors with pooled investments that have the collateral of the mortgages. However, the valuation of mortgage backed securities has been problematic.
The risk is limited as with mortgage backed securities each investor has ownership of an interest in the mortgage pool they have invested in and they will usually
be granted a guaranteed the full payment of their share of the interest and the principle either by a government sponsored enterprise (GSE), the government or a private insurer.
It should be noted that Fannie Mae and Freddie Mac are implicitly guarantees as they are government sponsored whereas GNMA has the full guarantee. The result of this is that
the risk if default is almost eliminated, making these very safe investments, but still potentially violate due to the repayment patterns of mortgagees and the influence of interest rates on
the returns that are created. This limits one type of risk, but there are other influences that carry risk, these include the risk of interest rates changed. Interest rates
are notoriously difficult to predict changing the level of income that is produced. In addition to this the main risk characteristic of this market is that of prepayment (Levin and
Davidson, 2005). It can be argued the most suitable model that should be used to value mortgage based securities is an options based model. Prepayments occur where a loan
is paid of early by a mortgagee shortening the terms and the value of the mortgage pool, the closer a mortgage s to maturity the greater the potential for prepayment
and the shortening of the income stream. Brennan and Schwartz (1977) have used a model where the prepayments are modelled as call options. However, this is not an ideal
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