Schweser says that “the average life of an MBS is the weighted average time until both scheduled principal and expected prepayments are received.” They go on to say "It’s simlar to Macaulay duration, except time is weighted by the projected principal to be be received at time t, rather than the PRESENT VALUE of the projected principal. I want to make sure I understand why the second part is true. I believe it is due to extension risk which is not present in a vanilla bond. If the MBS can undergo both contraction or extension risk then the life of the MBS can get shorter or longer. I think this is why the present value of the payments isn’t used (cash flows can go either way). With a vanilla bond we know the timing ofe flows so we can equate the future cash flows to a present value by discounting. Is this correct?
It’s because it’s just the average life, not a duration measure.
Uh…okay. Then why wouldn’t you use the present value of the scheduled and expected principal payments to determine your average life? The average life has to do with the underlying cash flows, which of course have to do with how the thing is valued presently. I don’t sleep anymore so my brain is mush and I am kind of punchy right now. Help.
I read somwhere on the internet that thought the true life of the MBS is 30 years, but usually the average life of the MBS turns out to be approx 7 yrs or so. Facrtoing in all the Best-Case, Base-Case and Worst-Case prepayment scenarios (contraction and extension risks). m bedridden today, so can’t grab onto my books to confirm anything of what I have said. will surely lookup further into it.