I think there might be an additional errata in Reading 23, Problem 3 in addition to what CFAI already put on their website. expected return on 10-year MBS (callable) should be 1.2% (risk-free rate) + 2.6% (long-term expected inflation) + .95% (MBS prepayment spread) + .80% (call spread) = 5.55% in their answer, they for some reason don’t include 80 bps (call spread) in calculation of expected return on 10-year MBS, and say it is 4.75%; however, for 10-year callable bond they use it. As a result, that screws up their overal investement expected return calculation. Am I missing something here? I don’t think I am.
I did that problem too…and I got it wrong. Same mistake! But I doubted myself, instead of CFAI.
Volkov, The prepayment spread for the MBS is the equivalent to the call spread for callable bonds. So adding it, takes care of the prepayment option in the MBS.
mo, I thought that callable MBS can have both, call and prepayment risk. I agree that both risks are triggered by decrease in interest rates. But couldn’t you have a situation when iterest rate drops, the rate of prepayments doesn’t change but MBS still gets called. If such a case can exist, I would expect call risk to be separate. What if, after drop in interest rates, prepayments increase, that shortens the average life of MBS (bad for me, but I was compensated for it through prepayment spread) but then at some point MBS still gets called. I guess I view these as two related but at the same time separate events, for which I am expected to be compensated. Maybe I am just overthinking it…
volkovv, I agree with you.
volkovv, I don’t remember reading about Callable MBS in Level 2 material , it was indicated that the prepayment feature is equivalent to a call option for the borrower, but I don’t remember reading about callable MBS. I have not yet covered the CFAI material for FI (I only did the problems). So I’ll have to get back to you on that one.
From the borrower standpoint ability to prepay is similar to a call option, no argument here. But from the investor standpoint, he is facing two risks, or I guess we can say two call options, one from the borrower accelerating prepayments (prepayment risk/quasi call risk) and another from the issuer itself being able to call the bond at opportune moment (true call risk), if in fact that is what implied by callable MBS. JoeyD maybe you can weigh in on this?
Working on the CME problems and got stuck on Reading 23 question 3 (Vol. 3, pg 111). I did a search and pulled this discussion from a few weeks back but it hasn’t been resolved. I think prepayment and call risk are different. What’s the concensus on this? Also why do we not add the 1 % maturity premium since its a 10 yr MBS?
I am still of an opinion that call and prepayment risk for MBS could be different. CFAI doesn’t seem to think so. In Reading 27 (Vol 3. pg324, Exhibit 3) they list prepament risk, sector risk, and convexity risk as risk factors of MBS but don’t mention call risk specifically. Myabe they are making an assumption that call risk is a sub-component of prepayment risk in the case of MBS. As far as 1% maturity premium, it sholdn’t be added because 10-year MBS prepayment risk spread in the problem inlcudes spread over 1-year Treasuries. Look at footnote ‘a’, it says “This spread implicitly includes a maturity premium in relation to the 1-year T-note as well as compensation for prepayment risk”
Good investigative work there volkovv, if the example shows that call risk wasn’t accounted for then it probably is assumed in the prepayment risk. as for the footnot, I must have read that at least five times. I don’t know why I still missed that. Think I’m burnt out abit!!!
I saw two problems among discussions. 1) suppose the mortgage security is callable to a lender, as a lender’s benefit instead of a risk, it should narrow the spread rather than widening it. (so 80 bps should be subtracted from instead of added to the overall spread. i.e. 3.95%) 2) callable feasure to a credit security (MBS in this case) is a hedge on rising interest rate instead of declining interest rate (i.e. a lender would like to call a bond if market rate becomes higher. the option allows her to issue a new bond of higher rate). so. the call should not be triggered by a drop in interest rate while the prepayment would. given above complexities, also given there’s no such thing as callable mortgage at least in current US market, CFAI simply treats prepayment and callable as synonyms in the context of mortgage securities. so. 4.75% is the plausible answer.
rand0m Wrote: ------------------------------------------------------- > I saw two problems among discussions. > > 1) suppose the mortgage security is callable to a > lender, as a lender’s benefit instead of a risk, > it should narrow the spread rather than widening > it. (so 80 bps should be subtracted from instead > of added to the overall spread. i.e. 3.95%) > > 2) callable feasure to a credit security (MBS in > this case) is a hedge on rising interest rate > instead of declining interest rate (i.e. a lender > would like to call a bond if market rate becomes > higher. the option allows her to issue a new bond > of higher rate). so. the call should not be > triggered by a drop in interest rate while the > prepayment would. > huh? Bonds are called when interest rates drop. Bond issuers don’t want to issue bonds at higher rates (why would anybody want to pay 8% instead of 6%?) > > given above complexities, also given there’s no > such thing as callable mortgage at least in > current US market, CFAI simply treats prepayment > and callable as synonyms in the context of > mortgage securities. so. 4.75% is the plausible > answer. I think that prepayable and callable is the same in MBS. I hear what is being suiggested here that there is an issuer who collects lots of pooled mortgages, chops them up, but then keeps a call option for themselves. The world is a big place and there has probaby been such a security but that’s not very typical since the prepayment option is hard enough to overcome without someone else having a call on the whole issue.
Re: CFAI Reading 23, Problem 3 (potential errata) Posted by: volkovv (IP Logged) [hide posts from this user] Date: March 12, 2008 07:51AM mo, I thought that callable MBS can have both, call and prepayment risk. I agree that both risks are triggered by decrease in interest rates … ********************************************************************* JoeyDVivre: I was commenting on an ealier comment as above. Do you think my view on callable is wrong?
rand0m Wrote: ------------------------------------------------------- > > mo, > > I thought that callable MBS can have both, call > and prepayment risk. I agree that both risks are > triggered by decrease in interest rates … > As I wrote earlier, I have not encountered the term " Callable MBS". I know the MBS has a built in implicit call option ( that you can hedge by buying a call option on a similar maturity bond as indicated later in the hedging reading), Thinking about it, I am not sure why the issuer would want to call the MBS. The borrower want to prepay, but why would the issuer call back the bond ?
the issuer may want to call the MBS (again not sure if this is done in practice) in case when interest rate drops, so he can repackage underlying mortgages into a new structure and reissue it with a lower coupon similar to any other coupon paying bond that can be called when interest rate is low enough and then reissued at a lower coupon
so lets get this straight, they are different but both operate when interest rates go down, difference is: Prepay - the option is on the lender Callable - the option is on the borrower Therefore, they are different BUT because they are both opted in the SAME DIRECTION (i rates going down) one supercedes the other. In other words, you can have both events occuring since the called bond no longer exists! Is that clear and am I right?
Level 2 material was more detailed in this area. As I remember it, when prepayments increase as int. rates fall, the different tranches of the MBS are terminated according to the seniority schedule, until the whole PAC issue becomes a Broken PAC when no more tranches can get the prepayments and that’s about it. I do not recall reading anywhere about the issuer calling back the MBS to re-issue it at lower rate. The issuer interests are aligned with the lenders and not the borrowers. He is paid for issuing the bond and servicing the payments. To make a long story short, unless someone who actually works with these things adds new information I would advise following the example in the CFAI readings.
UAECFA Wrote: ------------------------------------------------------- In other words, > you can have both events occuring since the called > bond no longer exists! > > Is that clear and am I right? sorry I meant to say that you CAN’T have both events occuring since the bond no longer exists! Just want to add, I assume that a prepayment by the borrower would occur first before a called bond would should i rates go down, therefore that would be the relevant risk measure. Any truth to this?
mo34 Wrote: ------------------------------------------------------- > I do not recall reading anywhere about the issuer > calling back the MBS to re-issue it at lower rate. > The issuer interests are aligned with the lenders > and not the borrowers. He is paid for issuing the > bond and servicing the payments. Then why would the question state “callable MBS” then?
rand0m Wrote: ------------------------------------------------------- > Re: CFAI Reading 23, Problem 3 (potential errata) > > Posted by: volkovv (IP Logged) > Date: March 12, 2008 07:51AM > > > mo, > > I thought that callable MBS can have both, call > and prepayment risk. I agree that both risks are > triggered by decrease in interest rates … > > ************************************************** > ******************* > > JoeyDVivre: > > I was commenting on an ealier comment as above. > Do you think my view on callable is wrong? Actually I reread it - “A lender would like to call the bond”