Mortgages and Mortgage‐backed Securities

Claus Munk

in Fixed Income Modelling

Published in print June 2011 | ISBN: 9780199575084
Published online September 2011 | e-ISBN: 9780191728648 | DOI:
Mortgages and Mortgage‐backed Securities

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In many countries, a mortgage is the standard way of financing the purchase of residential property, and mortgages are often financed by the issuance of bonds. This chapter focuses on the valuation of such mortgage-backed bonds. This is challenging since the cash flow to the bond owners depends on the payments that borrowers make on the underlying mortgages, and borrowers may default or choose to prepay — pay back outstanding debt earlier than scheduled — so that the actual cash flow to bond owners differs from the scheduled cash flow. The factors affecting prepayment behaviour are discussed. An option-based approach to the modelling of rational prepayments is explained and embedded in a standard valuation procedure. An alternative approach based on historical prepayment behaviour is also presented. Measures of the risk of investments in mortgage-backed bonds are briefly introduced. A brief overview of the role of mortgage-related securities in the financial crises and the burst of the housing market bubble in 2006–2007 is also given.

Keywords: mortgage; mortgage-backed bond; pass-through; prepayment; risk measures; collateralized mortgage obligations; subprime crisis

Chapter.  16482 words.  Illustrated.

Subjects: Financial Markets

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