CFAI 2007 qu 6c -Cash Flow Volatility Risk

An investment portfolio is heavily invested in MBS. What will be the impact of a rising interest rate environment on the portfolio’s Cash Flow volatility Risk ? Why a. Positive b. Negative c No effect

A

C?

B

i’d go B. up interest rates, you see less prepayments, so your CF’s are steadier. maybe not ideal vs where interest rates are, but less volatile yes?

wait- i’m confused on the q wording. i guess A (meaning it’s a good thing, downs the vol)… per my answer above.

i just dont get uncle CFA on this one: ‘The large holding in mortgage securities adds uncertainty tocash flows. When interest rates rise slowerp repaym,ent rates reduce cash inflows and associated interest on interest yield’ I was thinking that as interest rates rise, prepayments will reduce and this is a positve for the portfolio?

Maybe from a principal perspective… i.e. your duration’s extended because less prepayments. But from a cash flow perspective, I see their point that’s it’s less overall: * your (fixed-rate, I assume) mortgage pool’s paying you the same interest as before * because there’s less cash from redemptions in pool mortgages, you’re earning less $$ on reinvestment income. Maybe if they’re floating-rate mortgages, then it’s positive-to-neutral effect?

B. Increasing rates means investors will seek higher yielding investments elsewhere, causing you some risk in not getting your usual cashflows.

grace, please post the answer?

i did already…see my last post above…the asnwer is in quotes…u can also read the question from the CFAI 2007 ‘past’ questions and share ur views with us…

ok just looked this one over- note the question asks indicate the effect (pos/neg/neutral) on the company’s SURPLUS if the forecast is correct. it’s not asking the vol risk, it’s asking if it’s good/bad/neutral on the surplus. rates are rising. instead of you getting those principal payments faster and you being able to invest at higher prevailing interest rates, you’re locked into your MBS’s and are getting paid slowly. that makes sense.

bannisja, you make knowledge so attractive…thanks for this insight!