p. 171 of volume 4 of the CFA says that “…because of the prepayment option the duration of mortgage securities varies in an undesirable way as interest rate change: extending as rates rise and shortening as rates fall”. Isn’t it true that as rates rise, mortgage securities also will start behaving as normal bonds and exhibit positive convexitiy and hence when rates rise, the interest rate sensitivity eventually levels off. Hence, I would say that if rates rise a lot, duration actually shortens. Any ideas?
I would say no. If rates are at 5, and steadily, or continually rise to 30, no logical person would prepay. Duration would steadily increase, to it’s theoretical max. At a point, the MBS sensitivity to rates likely become Irrelevant. Just my thoughts .
for mortgage securities as rates rise, there is a possibility of the person who needs to make the payment on his/her house not being able to make the payment…therefore there is an extension risk, rates fall- prepayment occurs. Therefore the mortgage backed security will not act necessarily like a bond.