This ends the interest payments. The uncertain nature of the cash flows makes pricing IOs and POs difficult. The duration of a MBS can not be known with certainty. This is because of the borrower s prepayment option. Given any prepayments, the duration will be lower than the stated maturity of the mortgages underlying the security.
Duration aims to measure the price sensitivity of the security to interest rate changes.
For a fixed-income security, the sooner that the cash flows get returned the lower the duration and subsequent interest rate risk. However, the standard McCauley Duration can not be used for IOs and POs. For example, if interest rates rise, there are fewer prepayments and the present value of the principal payments falls, so the PO falls in value. On the other hand, fewer prepayments mean more interest payments and a correspondingly higher value for IOs. From the prepayment option comes both the difficulty in pricing and a major selling point of IOs.