Wednesday 4 June 2014

Risk and Return in Mortgage-backed Securities

The factor of risk and return in mortgage-backed securities is vary from level to level, this means that for each level of risk there is a different return, so this makes our concept clear that being a investor if you are investing in a security that is highly risky in a result of that risk you want high return in order to compensate that risk. 

As we know that there are major two types of investor, first one is Risk Taker; as from the name it is clear that Risk Taker are always ready to take risk in order to get high return, for example if you are risk taker and I offer you to select one security from two, you will select the security that have high level of risk. Second type of investor is Risk Averse; as from the name it is clear that Risk averse investors are always reluctant to take risk, in simple we can say that Risk Averse hates the factor of risk, for example if I give you two security, Security A, Risk of 10% while Security B, Risk Of 8%; So if you are the person who hates the risk always go for the security that have the comparative low level of risk, means you select the Security B.
Same is in the case of Mortgage-backed Securities; in general we can say that there are three level of risk in the mortgage-backed securities.

Risk Level in Mortgage-backed Securities

1. Highly Risky Securities
2. Moderate
3. Highly Secured Securities

So as we discuss earlier that it is depend on the nature of investor like Risk taker always go for the Highly Risky Securities while Risk averse always go for the Highly Secured Securities. Mostly all the Highly Secured securities are offered by the government, while others highly risky and moderate securities are offered by the Private agencies. In Figure 1B you can find the Precise Diagram of Risk and Return in Mortgage backed Securities.

Risk And Return In Mortgage-backed Securities, High Risk High Return, Low Risk Low Return
Figure 1B: Risk And Return In Mortgage-backed Securities

From the Figure it is very much clear that if you can bear high level of risk you will be rewarded by the high return, but keep one thing in mind that the default risk is very much high in Highly Risky securities and this risk will leads you towards the losing of you principle amount. For example if the borrower is unable to pay the amount of principle and interest, this thing will ultimately harms your security because you security is ultimately based on the cash flow of borrower of loan. Other thing is that in highly risky securities there is almost no collateral in some securities, means if the borrower of loan is unable to pay the principle plus interest then investment banks have nothing to sell in order to recover the Principle amount of loan. 

On the other hands if you are risk averse, you always go for the low risky option, and no doubt this option at least saves your principle amount of money that you spend in the security, so there is no way to lose anything in the Highly Secured Mortgage-backed Securities because the securities are backed by the government, other thing is that in Highly Secured Mortgage-backed Securities the value of collateral is also there means if the borrower is unable to  pay back the loan then government agency will just sell that collateral in order the get back the amount of loan plus interest, and this thing is extremely good in the perspective of investor, and that good that investor are not need to worry about whether the borrower of loan will be able to repay the loan or not. In simple we can say that in Highly Secured Mortgage backed securities there is a Win-Win Situation for the Investor.

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