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Definition: Stripped MBS
It is a type of Mortgage Backed Security whose cash flow is derived from the principal repayment and interest rate repayment on under laying asset. To increase the attractiveness to Mortgage backed Security the cash flows derived from underlying asset are divided in to interest and principal. In case of conventional MBS both interest and principal are used to derive cash flows.
Principal-only-strips and interest-only-strips have some fundamental differences. The payment timing of Principal-only-strips is unknown but dollar amount is known. It is sold at a discount determined by the rate of interest and speed of prepayment on face value. In case of Interest-only-Strips level of Cash flows are high during earlier years and substantially low during later years.
Due to structural differences Principal-only-strips and interest-Only Strips behaves in a opposite manner with interest rate changes. If interest increases the cash flow discount rate will also increase. As a result price of principal only strips will come down. But as payment levels are reduced by rising rates, mortgages will last longer. Hence the price will increase for interest-only-strips. Opposite phenomena will be observed if interest rates are in a decline.