So aside from being in the positive convexity side of the yield-price curve, MBS will have lower duration than a similar option-free bond - thus, resulting in less price gain when rates decrease but also less price loss when rates increase? So it’s not a lose-lose…
Correct.
This still isn’t resolved for me. I keep going back to the formula – if convexity is negative it is going to make the percentage loss BIGGER when rates rise. (substitute numbers in and see…)
I understand the logic of the prepayment option declining in value (therefore callables outperform) but I do not understand how this relates back to the duration and convexity formula.
Anyone?
If convexity is negative and the duration is the same; the point is that _ the duration isn’t the same _: the duration of a callable bond in the region where its convexity is negative is _ less than _ the duration of the option free bond.