Question

(a) Assume that a $200m Mortgage Backed Bond (MBB) is issued against a $300m pool, in denominations of $10,000 for a period of 10 years. The coupon rate was set at 8.00% pa. Also assume that the MBB is given a rating of AAA and that the market rate of return required by investors is 9%pa Calculate the price at which the security will be offered on the date of issue (20%) Discuss the market developments where mortgage backed securities would be an efficient instrument that a hedge fund could use to diversify into the real estate sector. (20%)

Answer 1

Bond Par Value = $ 10000, Coupon = 8 % per annum payable annually, Required Yield = 9 % per annum Bond Tenure = 10 years

Annual Coupon = 0.08 x 10000 = $ 800

Therefore, Issue Price = 800 x (1/0.09) x [1-{1/(1.09)^(10)}] x [10000 / (1.09)^(10)] = $ 9358,234

A mortgage-backed security uses cash flows servicing the mortgage as returns for investors investing in MBBs. These instruments would be efficient for diversification into the real estate sector in conditions of low mortgage rates (and hence overall interest rates) as that would imply easier servicing of the mortgages which in turn would ensure a steady cash flow to the holders of the these MBBs. It would be efficient in the sense that MBB holders would benefit from the steady stream of mortgage servicing cash flows without being directly exposed to lendings in the real estate market.