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Mortgage Cash Flow We model the closed monthly cash flows from a pool of mortgage. Here cash flows consist of principal and interest payments. Principal payments arise from the regular amortization of principal, as well as from scheduled and unscheduled principal pre-payments. Unscheduled principal pre-payments model liquidation events caused, for example, • by the death of the homeowner, or • the homeowner having to relocate. A liquidation event is assumed to be independent of the interest rates prevailing at the time of its occurrence. We assume that the cash flows from a mortgage pool occur on the first day of each future month. Here the first day of the month from the valuation date is mapped to the value We understand that a robust day counting scheme, which also takes into account holiday schedules In the above, the weighted average coupon is expressed as an annualized, semi-annually compounded percentage, and the scheduled and unscheduled principal pre-payment rates are both given as annualized, annually compounded percentages. An equivalent, monthly compounded unscheduled pre-payment rate, U, is similarly calculated. These cash flows are determined sequentially as described below. Unscheduled principal pre-payments model liquidation events, and are subject to penalty interest. Since the mortgage is closed, the homeowner is legally bound to cover the full interest rate differential (IRD) upon liquidation. The treatment of penalty interest varies from branch to branch, and that the homeowner does not typically pay the full IRD. In practice the penalty interest from liquidating a closed mortgage may be taken as bigger than zero but less than the full IRD.
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