Fixed Income Securities, In Class Computer Assignment on PSA

In this assignment, we are going to build a spreadsheet to model the cash flows of a
mortgage-backed security, taking into account prepayments. We are also going to
calculate the yield of the security and its weighted average life.

You will email me the spreadsheet and answers to the discussion questions at the end of
this document. You can answer the discussion questions by hand on this piece of paper or
put them in a word or excel document to email to me.

In the spreadsheet, anything that is highlighted in green is something that has a

formula already written, and you should not change it.

You must complete everything that is in yellow.

1. Starting with the spreadsheet template provided, in the yellow input area, please input
the following information about a mortgage-backed security. Please do not fill in the
regular payment cell (C6) it will calculate automatically.

PSA 200
Principal Balance 100,000,000
WAC 4.000%
Pass-Through Coupon 3.500%
Regular Payment
Original term 355
# of months remaining 340

2. Starting with the first row of the spreadsheet, write formulas to calculate all required
information.
HINTS
a. “Period” is when the bond’s next cash flow will come. Note that the original term of
the bond was 355 months, and there are 340 months remaining. Therefore, a certain
number of months have passed. Your bond is starting with the “next” month.

b. Beginning balance is the beginning balance each month.

c. CPR is the annual conditional prepayment rate for the bond, and is a formula. I put it in
here; you need to copy it down to all the cells. You should take a look at it and try to be
sure you understand it. Effectively, CPR is increasing in the first 30 months of a bond’s
life, and flattens out after that. It is directly influenced by the PSA.

d. SMM is the monthly version of CPR. You have a formula in the slides. You need to
write this formula and copy it down to all the cells.

e. The payment is a formula. It is input for the first line. You will need to copy it down to
all the cells. Note that the PSA model assumes the payment adjusts each period to
account for prepayments in the prior period. This allows the bond to amortize exactly
over its remaining life.

f. Interest is a formula you need to write. Remember, you calculate interest on the MBS
using the pass-through rate, since this is the interest that will go to the outside investors
(the whole spreadsheet is from the perspective of outside investors). You need to write
this formula and copy it down to all the cells.

g. Servicing fee is the fee that is paid to the servicer of the MBS for insurance and
administration. It is based on the spread between the WAC and the pass through rate.
You need to write this formula and copy it down to all the cells.

h. Regular principal is a formula based on the payment – interest – servicing fee. You
need to write this formula and copy it down to all the cells.

i. Prepayment is based on the SMM (see your slides) You need to write this formula and
copy it down to all the cells.

j. Total principal is sum of regular principal and prepayment. The formula is in line 1,
You need to copy it down to all the cells.

j. Ending balance is beginning balance less total principal. You need to write this formula
and copy it down to all the cells.

k. Net cash flow is the total cash flow for the month that is received by the investor in the
MBS, which is the total principal plus interest. You need to write this formula and copy it
down to all the cells.

Once you have the first row done, you should be able to copy it down to the end. You
know the spreadsheet is correct if your ending balance is $0 (i.e., the mortgage is
completely paid off at the end of the term).

3. Now calculate the weighted average life (see at the top and cell N354). Weighted
average life is calculated as in the slides. There is a hint near cell N354 to help you. There
is a formula in Cell F2 to bring this up to the top of the spreadsheet.

4. Finally, you have to calculate cash flow yield. In our slides, we cover cash flow yield.
You first calculate the monthly IRR, which is in a formula at the top of the spreadsheet
(cell M2). Take a look at this formula. It is taking the internal rate of return for the net
cash flows. The net cash flows are in column M and include the outflow (the initial price
paid for the bond, which I have initially set = par value of $100MM) and all the inflows
from the bond’s interest and principal. The MONTHLY IRR for this stream of cash flows
is given by the Excel formula IRR.

Given the monthly IRR, you need to turn it into a semiannual IRR, and then calculate the
BEY. The slides will guide you with this.
Discussion Questions (answer here or somewhere in the spreadsheet)

Cash flow yield and WAL

5a Write down the cash flow yield when the price is at 90,000,000 and 200 PSA. 5.583
write down the WAL: 6.55

b. Keep the price at 90,000,000 and change PSA to 50. write down the yield: 4.651
write down the WAL: 12.69
*Is the yield higher or lower than the yield in a? lower
*Is the WAL higher or lower than the WAL in a? higher

c. Keep the price at 90,000,000 and change the PSA to 400. write down the yield: 6.960
write down the WAL: 3.66
*Is the yield higher or lower than the yield in a? higher
*Is the WAL higher or lower than the WAL in a? lower

d. What general “rule” can you state about the relationship between a bond priced at a
discount to par, its PSA, and its cash flow yield? Why? (seeing how WAL changes will
help you answer this question)

Higher PSA means you get the cash flows more quickly so that each monthly cash
flow is higher than it would otherwise be. Since you did not pay for all the principal
(you bought the bond at a discount), you are getting back principal more quickly
which improves your return on investment. Although your interest cash flows are
lower, the “getting back early” of the principal more than offsets this and your yield
improves.

6a Write down the cash flow yield when the price is at 110,000,000 and 200 PSA. 1.813
Write down the WAL: 6.55

b. Keep the price at 110,000,000 and change PSA to 50. write down the yield: 2.491
write down the WAL: 12.69
*Is the yield higher or lower than the yield in a? higher
*Is the WAL higher or lower than the WAL in a? lower

c. Keep the price at 110,000,000 and change the PSA to 400. write down the yield: 0.706
write down the WAL: 3.66
*Is the yield higher or lower than the yield in a? lower
*Is the WAL higher or lower than the WAL in a? higher

d. What general “rule” can you state about the relationship between a bond priced at a
premium to par, its PSA, and its cash flow yield? Why? (seeing how WAL changes will
help you answer this question)
Higher PSA means you get the cash flows more quickly (WAL is shorter) so that
each monthly cash flow is higher than it would otherwise be. Since you paid “extra”
for the principal (you bought the bond at a premium), when you get back this
principal “early”, it is not available to earn interest, which reduces your interest
cash flows and hurts your return.

7a Write down the cash flow yield when the price is at 100,000,000 and 200 PSA. 3.521
write down the WAL: 6.55

b. Keep the price at 100,000,000 and change PSA to 50. write down the yield: : 3.483
write down the WAL: 12.69
*Is the yield higher or lower than the yield in a? lower
*Is the WAL higher or lower than the WAL in a? higher

c. Keep the price at 100,000,000 and change the PSA to 400. write down the yield: 3.525
write down the WAL: 3.66
*Is the yield higher or lower than the yield in b? higher
*Is the WAL higher or lower than the WAL in a? lower

d. What general “rule” can you state about the relationship between a bond priced at par,
its PSA, and its cash flow yield? (HINT: the cash flow yield should not change much)

PSA does not affect cash flow yield very much for a bond priced at par.