The cash flows to Canadian mortgage-backed securities (MBSs) are determined by the cash flows to the underlying pool of residential mortgages. Canadian mortgages tend to have shorter terms than their U.S. counterparts. Furthermore, because mortgage interest payments are not tax-deductible in Canada, Canadian mortgages offer a rich menu of prepayment privileges.
Because of these prepayment conditions, Canadian MBSs can exhibit very different behavior from normal debt securities. In particular, as interest rates fall, the price of an MBS will rise, peak and then start to fall again, reflecting the relation between interest rate levels and the volume of prepayments. A model that incorporates an explicit relation between prepayment rates and interest rates can be used to price Canadian MBSs under a variety of economic conditions.
