NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Arnold S. Kling

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NBER Working Papers and Publications

August 1987Interest-Only/Principal-Only Mortgage-Backed Strips: A Valuation and Risk Analysis
with Alan J. Marcus: w2340
We examine the risk characteristics of each portion of IO/PO mortgage strips, present results of a valuation model of these securities, and examine market prices of both the interest-only and principal-only portions of mortgage pools. We show that IO/PO securities are highly sensitive to the prepayment behavior of the underlying mortgage pool. Because that behavior varies systematically with the interest rate, and because prepayments affect the values of I0 and PO components in opposite ways, the interest-rate risk of strip securities can differ substantially from that of the underlying mortgage pool. The PO component has much longer duration than the underlying mortgage pool. In contrast, the IO component typically will have a negative duration, at least in ranges for which interest-rate ...
 
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