An investor is consdering the purchase of either an IO and PO from CMO offering.

Question

An investor is consdering the purchase of either an IO and PO from CMO offering. The portion of the mortgage pool backing is 10 years and an 8% interest rate. Assume annual payments and a zero prepayment rate Required: a) If the interest rate demanded by investors on this investment is 8%, caqlculate the value of IO and PO b) i)If the market rates increased to 10%, calculate the value of IO and PO strips ii) Which security, the IO or PO exhibits the greatest price change from (a) above. Explain why?

Explanation / Answer

Assume Face value =$1000

Annual Interest= $1000*8% = $80

Value of IO Strip = Annual Interest* Sum of FVF at 8% for 10 year

= $80* 6.71= $536.80

Value of PO Strip = Maturity Amount*PVF for year 10

= $1000*0.46319= $463.19

B- If Market Interest rate increased to 10%

  Value of IO Strip = $80* 6.1445 = $491.56

Value of PO Strip = $1000* 0.3855= $385.50

Change in PO Price= $463.19-$385.50= $77.69

Change in IO Price =$536.80-$491.56= $45.24

Price of PO Strip has been changed more than change in IO Strip.

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