one of 2007 exam question concludes that rising interest rate is of negative impact in terms of cash flow risk to a MBA holdings. the cited reason is slower prepayment rate. if i could turn the question around, what would be the effect of cash flow risk in case when interest rate is declining? (positive, negative, or no effect).
MBA-you mean mortgage backed ?
ok they probably ment that declining interest rates cause increase in cash flow volatility - rising cash flow risk
when i did the original question, my answer was “no effect”, which is wrong. i was thinking, in a relatively high rate environment, prepayment becomes a lot more steady/predictable (mainly from sales of properties). as a result, cash flows to mortgage backed securities should be less volatile. since i was wrong on that one, i kind of asked myself, what if interest rate is down, in that situation, would cash flow risk become even worse? if so, i am relieved, mba is just bad in terms of cash flow risk. btw, MBA = mortgage backed assets