It is a well known fact that the value of a financial claim reflects the present value of the cash flows produced by the financial claim. While valuing an MBS an important thing to be decided upon is with regard to the cash flows, given the nature of the underlying mortgage contracts.
To an MBS investor, cash flows comprises three components,
CF_{t} = NI_{t} + SP_{t} + PR_{t}
Where,
CF_{t} = total cash flow to investor.
NI_{t} =_{ }monthly interest payment net of servicing and other fees.
SP_{t} = scheduled principal payment for month t.
PR_{t} = forecasted unscheduled principal repayments in month t (prepayments).
The significant amount is the prepayment PR_{t}, which occurs at the discretion of the borrowers.
The following table shows the mechanics of a classical pass through MBS.
Table
Payments of mortgage borrower: PR_{t} + SP_{t} + I_{t}

Repayments: PR_{t} + SP_{t}

(Gross) Interest coupon payments: I_{t} = i MB_{t1}

Forecasted unscheduled prepayment: PR_{t}

Monthly scheduled payment of borrowers (coupon plus amortization on mortgage balance)
MP_{t} = MB_{t1}

Prepayments
PR_{t} = SMM_{t} (MB_{t1})  SP_{t})

Scheduled repayments
SP_{t} = MP_{t}  I_{t}

Interest net of service fees
NL_{t} = MB_{t1} (i  s)

Service fee (going to servicer)
St = s MB_{t1}

Cash flow to MBS investors: CF_{t} = PR_{t} + SP_{t} + I_{t}  S_{t} = PR_{t} + SP_{t} + NI_{t}


Where,
I_{t} = Gross interest coupon payments
MB_{t} = Mortgage balance
MP_{t} = Monthly scheduled payment of borrowers
SMM_{t} =_{ }Standard monthly mortality rate, i.e. prepayment rate, which can also be modelled using more sophisticated econometric techniques
S_{t} =_{ }Servicing fee.
Based on the mortgage balance from the previous month, the above process is repeated.
The link between the months follows the dynamic stock adjustment equation
MB_{t}  MB_{t1} = PR_{t} + SP_{t}
Through this equation, the events of one period affect the cash flows of all consequent periods. This is also called pathdependency. Undoubtedly, if it was not for the uncertainty of the prepayments, PR_{t}, the process would be perfectly predictable on the basis of knowledge of i, s, n, and MB_{0}.