Q. 1: Look at Exhibit 5 and using the assumptions, recreate the table using the following assumption: assume principal remains at $5/month but the write-downs are $20 beginning at month 6.
Ans. Table:
| Month | Principal Write-down on bond | Outstanding Face value of the bond | Notional Size of Swap | Fixed Swap payment | Floating Rate Payment | Net Cash flow to Buyer |
| 0 | 300 | 1000.0 | ||||
| 1 | 0 | 295 | 983.3 | 5.83 | 0.00 | -5.83 |
| 2 | 0 | 290 | 966.7 | 5.74 | 0.00 | -5.74 |
| 3 | 0 | 285 | 950.0 | 5.64 | 0.00 | -5.64 |
| 4 | 0 | 280 | 933.3 | 5.54 | 0.00 | -5.54 |
| 5 | 0 | 275 | 916.7 | 5.44 | 0.00 | -5.44 |
| 6 | 0 | 270 | 900.0 | 5.35 | 0.00 | -5.35 |
| 7 | 0 | 265 | 883.3 | 5.25 | 0.00 | -5.25 |
| 8 | 0 | 260 | 866.7 | 5.15 | 0.00 | -5.15 |
| 9 | 0 | 255 | 850.0 | 5.06 | 0.00 | -5.06 |
| 10 | 0 | 250 | 833.3 | 4.96 | 0.00 | -4.96 |
| 11 | 20 | 225 | 783.3 | 4.86 | 66.67 | 61.81 |
| 12 | 20 | 200 | 733.3 | 4.57 | 69.63 | 65.06 |
Q. 2: Based upon our previous discussions around risk, which ones could be associated with this transaction?
According to our transactions, provided above are the two types of risks which are associated here; the default risk and the prepayment risk.
The default risk is the total risk which can be associated with the risk of the home owner together missing out on the payments of the mortgage. If this happens then this is a direct loss for the organization, and for this type of risk, there is always a chance for the owner to re-finance their mortgages through acquiring another loan or incentive. If this happens then it is a direct loss for our MBS as it is connected to the loss under the payments.
Another type of risk which is affecting is the prepayment risks.This is affecting our transaction as the principal written down value is $20. This risk is officially concerned for the organizations issuing the security being backed by mortgage. If the whole prepayment is clear then all the risk for our transaction directly falls on the entity as the source at which is being backed is not available anymore.
The value deduction for this statement is beneficial for the organization as this creates humongous profits on the Security. The Net current Cash flow is showing a heavy profit as the face value being decreased increases the value of the security.
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Q. 3: What happens to the pool if there is a sudden $290MM principal repayment? What would deal look like? (Exhibit 10)
If there is a sudden $290 M principal repayment, then this will become part of the prepayment risk which we have considered in the above example of our question. If this happens then the value of the bond will decrease creating a loss for the swap buyer and high profits for the swap seller as this will decrease the pool size in which the bond is securitized.
The deal would look inconsiderate as this will create a loss factor for the swap buyer and for Mr. Keating – this will be termed as a loss as this will create heavy losses for his client pool, which might be the potential factor for him losing his job..............
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