Question: Using a Monte Carlo simulation approach, determine the theoretical value of an MBS issue with a face value of $1,000,000, WAC = 8%, WAM =

Using a Monte Carlo simulation approach, determine the theoretical value of an MBS issue with a face value of $1,000,000, WAC = 8%, WAM = 10 years, PT rate = 8%, annual cash flows (instead of the standard monthly), and a balloon at the end of the second year.

Assume:

The current one-year spot rate is S0 = 6% and the current refinancing rate is R0 ref = 8%.

The future spot and refinancing rates can both be described by a two-period binomial interest rate where u = 1.1, d = 1/1.1, the length of the period is one year, and q = .5.

The following prepayment model applies:
CPR = 20% if (WAC − Rref) > 0 CPR = 5% if (WAC − Rref) ≤ 0 A risk-adjusted one-year spot rate is equal to the spot rate plus an optionadjusted spread of 2%: SRA = S + 2%.

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