Explanation:
From an investor's perspective, a mortgage-backed security (MBS) is equivalent to holding:
This is because the borrower (homeowner) has the right to prepay the mortgage when interest rates fall, which is economically equivalent to the borrower holding a call option on the mortgage. The investor is effectively short this call option, as they lose the higher-yielding investment when prepayment occurs.
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From an investor's point of view, a mortgage-backed security is equivalent to holding a long position in a non-prepayable mortgage pool and which of the following?
A
A long American call option on the underlying pool of mortgages.
B
A short American call option on the underlying pool of mortgages.
C
A short European put option on the underlying pool of mortgages.
D
A long American put option on the underlying pool of mortgages.
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