Consider a 10-year, fixed-rate mortgage of $500,000 that has an interest rate of 12 percent. For simplification assume that payments are made annually.
a. Determine the amortization schedule.
b. Using your answer in a, determine the value of both IO and PO strips with a discount rate of 10 percent under the assumption that the mortgage will not be prepaid.
c. Now recompute the values of the IO and PO under the assumption that interest rates immediately fall to 8 percent and the mortgage is prepaid in year 6.
d. Explain the risk characteristics of IO and PO strips.