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Suppose we have a new type of MBS to accommodate the short-term investor. This new MBS security instrument contains only 3-year mortgages (in reality are rare if non-existent). ACME, a private secondary mortgage market, has pooled together ten $100,000 3-year mortgage loans. Note: To save space in writing out your work, you can scale the ten $100,000 to $100. Calculate the duration for this MBS pool assuming annual compounding for three years at 10 percent interest which a. is a “zero coupon”. b. is an interest-only MBS. Page 1 of 4 c. is fully amortizable over the three years. Page 2 of 4

2. Now assume that the interest-only MBS in problem 1b. is prepayable (but not defaultable). Use the option-theoretic model to price this MBS. Interest rates have a 50% chance of going up 1% each year and a 50% chance of going down 1% each year. From your results, qualitatively compare the MBS value without prepayment to the MBS value with prepayment. Note: To save space in writing out your work, you can scale the ten $100,000 to $100. – in your solution show the work/setup which includes the calculations for all steps

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