This example illustrates how the Financial Toolbox™ and Financial Instruments Toolbox™ are used to price a level mortgage backed security using the BDT model.

```
load mbsexample.mat
```

Visualize the interest rate evolution along the tree by looking at the output structure BDTTree. BDTTree returns an inverse discount tree, which you can convert into an interest-rate tree with the `cvtree`

function.

BDTTreeR = cvtree(BDTTree);

Look at the upper branch and lower branch paths of the tree:

OldFormat = get(0, 'format'); format short %Rate at root node: RateRoot = treepath(BDTTreeR.RateTree, [0]) %Rates along upper branch: RatePathUp = treepath(BDTTreeR.RateTree, [1 1 1 1 1]) %Rates along lower branch: RatePathDown = treepath(BDTTreeR.RateTree, [2 2 2 2 2])

RateRoot = 0.0399 RatePathUp = 0.0399 0.0397 0.0391 0.0383 0.0373 0.0360 RatePathDown = 0.0399 0.0470 0.0550 0.0638 0.0734 0.0841

Let's say that we have a 3 year $10000 level prepayable loan, with a mortgage interest rate of 4.64% semi-annually compounded.

MortgageAmount = 10000; CouponRate = 0.0464; Period = 2; Settle='01-Jan-2007'; Maturity='01-Jan-2010'; Compounding = BDTTree.TimeSpec.Compounding; format bank

Use the function `amortize`

in the Financial Toolbox to calculate the mortgage payment of the loan (MP), the interest and principal components, and the outstanding principal balance.

NumPeriods = date2time(Settle,Maturity, Compounding)'; [Principal, InterestPayment, OutstandingBalance, MP] = amortize(CouponRate/Period, NumPeriods, MortgageAmount); % Display Principal, Interest and Outstanding balances PrincipalAmount = Principal' InterestPaymentAmount = InterestPayment' OutstandingBalanceAmount =OutstandingBalance' CFlowAmounts = MP*ones(1,NumPeriods); % The CFlowDates are the same as the tree level dates CFlowDates= {'01-Jul-2007' ,'01-Jan-2008' ,'01-Jul-2008' , '01-Jan-2009' , '01-Jul-2009' , '01-Jan-2010'} ; % Calculate the price of the non-prepayable mortgage [PriceNonPrepayableMortgage, PriceTreeNonPrepayableMortgage] = cfbybdt(BDTTree, CFlowAmounts, CFlowDates, Settle); for iLevel = 2:length(PriceTreeNonPrepayableMortgage.PTree) PriceTreeNonPrepayableMortgage.PTree{iLevel}(:,:)= PriceTreeNonPrepayableMortgage.PTree{iLevel}(:,:) - MP; end % Look at the price of the mortgage today (tObs = 0) PriceNonPrepayableMortgage % The value of the non-prepayable mortgage is $10017.47. This value exceeds % the $10000 amount borrowed since the homeowner received not only $10000, but % also a prepayment option. % Look at the value of the mortgage on the last date, right after the last % mortgage payment, is zero: PriceTreeNonPrepayableMortgage.PTree{end}; % Visualize the price tree for the non-prepayable mortgage. treeviewer(PriceTreeNonPrepayableMortgage)

PrincipalAmount = 1572.59 1609.07 1646.40 1684.60 1723.68 1763.67 InterestPaymentAmount = 232.00 195.52 158.19 119.99 80.91 40.92 OutstandingBalanceAmount = 8427.41 6818.34 5171.94 3487.35 1763.67 0.00 PriceNonPrepayableMortgage = 10017.47

% The Prepayment option is like a call option on a bond. % % The exercise price or strike will be equal to the outstanding principal amount % which has been calculated using the function amortize. OptSpec = 'call'; Strike = [MortgageAmount OutstandingBalance]; ExerciseDates =[Settle CFlowDates]; AmericanOpt = 0; Maturity = CFlowDates(end); % Compute the price of the prepayment option: [PricePrepaymentOption, PriceTreePrepaymentOption] = prepaymentbybdt(BDTTree, OptSpec, Strike, ExerciseDates, AmericanOpt, ... 0, Settle, Maturity,[], [], [], ... [], [], [], [], 0, [], CFlowAmounts); % Look at the price of the prepayment option today (tObs = 0) PricePrepaymentOption % The value of the prepayment option is $17.47 as expected. % Visualize the price tree for the prepayment option treeviewer(PriceTreePrepaymentOption)

PricePrepaymentOption = 17.47

% Compute the price of the prepayable mortgage. PricePrepayableMortgage = PriceNonPrepayableMortgage - PricePrepaymentOption; PriceTreePrepayableMortgage = PriceTreeNonPrepayableMortgage; for iLevel = 1:length(PriceTreeNonPrepayableMortgage.PTree) PriceTreePrepayableMortgage.PTree{iLevel}(:,:)= PriceTreeNonPrepayableMortgage.PTree{iLevel}(:,:) - ... PriceTreePrepaymentOption.PTree{iLevel}(:,:); end % Look at the price of the prepayable mortgage today (tObs = 0) PricePrepayableMortgage % The value of the prepayable mortgage is $10000 as expected. % Visualize the price and price tree for the prepayable mortgage treeviewer(PriceTreePrepayableMortgage) set(0, 'format', OldFormat);

PricePrepayableMortgage = 10000.00

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