Not sure I understand this? I understand that interest rates are increasing. however, the duration of our assets is greater than our liabilities this would lead me to conclude that we will be able to return a higher reivestment on our assets but, our liabilities will be increasing at a higher rate because they are more shorter term. the combination of those two would lead to a lower surplus. wouldn’t it? what am I missing? thanks all
well, i don’t have the Q in front of me. But you’re missing the value of your current position which is what leads to a lower surplus. It doesn’t really have much to do with the returns you can earn in the future (which is what you were talking about in your post)… But if Da>Dl then if rates rise, the value of your assets will decrease more than the value of your liabilitis, shrinking your equity base (surplus).
Striker, your answer is what I said originally as well. that’s not the case however. No worries, I know you don’t have the question with you… however, the CFA answer says that The surplus will increase? given that interest rates are increasing and the Duration of the liabilities is less than the Duration of the assets? I’m not really understanding how? I think it may be because of the MBS in the portfolio? which is stated in the answer key. however, I don’t know how those can still grow at a faster rate than the liabilities?
what’s the answer key say? have you checked for errata?
if you are referring to 6C.IV then “increase in interest rates” will increase the return for reinvestment of coupons and dividends => increase surplus. you are making your thinking over complexed by confusing yourself with valuation risk (which is what you are talking about, as above) versus the standalone issue of reinvestment risk.
it’s the 2007 CFAI exam. there shouldn’t be any errata on that. it say’s “the reinvestment risk/return of coupon and principal payments from corporate bonds and mortgage securities is influenced by interest rate volatility. higher interest rates will lead to higher reinvestment rates, which would have a positive impact on surplus.”
what’s the question (i am willing to guess what the question is based on the answer) and if the quesiton is as i think it is, i probably have an answer for you. (how do you like that awkwardly worded sentence?)
I get it now… Reinvestment risk implies duration of assets is less than duration of liabilities. therefore when we throw the assumption that interest rates are increasing. we know that reinestment risk falls and therefore the surplus will increase! thanks Edge, Striker. Striker - I know you were channelling the answer to me…
I have another question for the same question. Can sb explain the cash flow volatility risk with MBS when interest rate rises? I have been thinking that cash flow volatility due to intermediation can be even more serious. - sticky
Not sure what reinvestment risk has to do with duration, but in any case if you want to drag that in since duration of liability > duration of assets, your equity/surplus will increase, and once you get a coupon payment you can reinvest it at a higher rate. when IR rises prepayment slows down what do you mean by cf volatility due to intermediation?
thetank Wrote: ------------------------------------------------------- > what do you mean by cf volatility due to > intermediation? I thought with intermediation, the unexpected (required) cash flow is another form of CF volatility that contribute to the risk that insurance companies are facing. But my original question is: Why is there cash flow volatility risk with MBS when interest rate rises? For background please refer to the solution to the exam question. - sticky
Don’t think reinvestment risk is the point of the question as it relates to interest rate risk. Because your assets have a higher duration then liabilities, they are thus more sensitive to an increase in rates (ie they will decline in value more so that the value of your liabilities). Therefore you could wind up with a negative surplus. As far as reinvestment goes, this is positive for the overall surplus as you can reinvest your coupons at higher rates.
Sticky, when interest rate rises, less housing owners are willing to prepay their mortgage loans, translating into less cash flow in MBS than before. But when interest rate drops, prepayment follows. It seems cash flow volatility always exist for MBS irregardless of the direction of rate change.
jimmylegs Wrote: ------------------------------------------------------- > Don’t think reinvestment risk is the point of the > question as it relates to interest rate risk. > Because your assets have a higher duration then > liabilities, they are thus more sensitive to an > increase in rates (ie they will decline in value > more so that the value of your liabilities). > Therefore you could wind up with a negative > surplus. > > As far as reinvestment goes, this is positive for > the overall surplus as you can reinvest your > coupons at higher rates. if duration of your assets would be lower then duration of your liabilities and interest rates were decreasing then you are faced with reinvestment risk i believe
tommy2004 Wrote: ------------------------------------------------------- > Sticky, when interest rate rises, less housing > owners are willing to prepay their mortgage loans, > translating into less cash flow in MBS than > before. But when interest rate drops, prepayment > follows. It seems cash flow volatility always > exist for MBS irregardless of the direction of > rate change. So there is always cash flow volatility risk with MBS? 
i going up => less prepayment => wow that’s volatility i going down => more prepayment => wow that’s volatility again You are really bullshxting me, CFAI … but I will just remember this Thanks tommy2004. - sticky
tommy2004 Wrote: ------------------------------------------------------- > Sticky, when interest rate rises, less housing > owners are willing to prepay their mortgage loans, > translating into less cash flow in MBS than > before. But when interest rate drops, prepayment > follows. It seems cash flow volatility always > exist for MBS irregardless of the direction of > rate change. would you consider disintermediation (due to higher i) another (major) source of cash flow volatility? - sticky