Fixed Income Quiz

CFA Level III
#1

You are a fixed income manager with a strong belief that interest rates will decline sharplyn from their current high levels in the near future. Which of the following is most likely to be your recommendation for the asset allocation in your portfolio? A: Underweight low coupon MBS and overweight Treasuries B: Underweight high coupon MBS and overweight Treasuries C: Overweight high coupon MBS and underweight Treasuries D: Overweight low coupn MBS and underweight Treasuries

#2

d?

#3

B

#4

b

#5

B

#6

The answer is: B High coupon MBS will experience the most price compression when rates drop so it makes sense to overallocate to Treasuries which are not prepayable and therefore have no cap on their upper value. I didn’t get the ‘High coupon MBS will experience the most price compression when rates drop’ part. Could you explain please

#7

due to your premayment rate which will increase because (e.g.) homeowners can re-finance their mortgage at lower costs therefore will diminish the total return, then impact on price, etc etc…

#8

understand the negative convexity due to prepayments but why will it be higher for high coupon MBS than for low coupon MBS

#9

Negative convexity for MBS securities occurs when the Yield falls below the coupon. Thus a Higher Coupon bond will experience negative convexity before a lower coupon bond does. thus it would be in your best interest to underweight the higher coupon bond 1st then the lower coupon bond.

#10

I made a drawing so you can all better understand http://imageshack.us/photo/my-images/94/unledsu.jpg/

#11

This question was asked a few days ago. 1) MBS Prepayment risk: Higher coupon MBS, whose undelying loans usually have higher loan raetes, may experience higher prepayments(by refinancing) when rate goes down. So low-coupon MBS is a better choice. 2) On the other hand, low-coupon MBS has a larger duration - this may mitigate the prepayment risk when interest rate goes down. The answer in curriculum simply says that low-coupon bond exhibits a less negative convexity. So we may not need to know why in the exam…IMHO, many MBS related materials are usually based on empirical study.

#12

sorry im late again first thing is …forget about MBS focus on treas…if interest rates decline u def want to be overweight treas…this allows u to throw out 2 answers straight out the bat C & D… now back to MBS …as stated earlier Re: Fixed Income Quiz new Posted by: Pauluss (IP Logged) Date: May 9, 2011 07:15AM due to your premayment rate which will increase because (e.g.) homeowners can re-finance their mortgage at lower costs therefore will diminish the total return, then impact on price, etc etc…

#13

Not a cuspy-coupon mortgage securities?

#14

deriv108 Wrote: ------------------------------------------------------- > This question was asked a few days ago. > > 1) MBS Prepayment risk: Higher coupon MBS, whose > undelying loans usually have higher loan raetes, > may experience higher prepayments(by refinancing) > when rate goes down. So low-coupon MBS is a better > choice. > > 2) On the other hand, low-coupon MBS has a larger > duration - this may mitigate the prepayment risk > when interest rate goes down. > > The answer in curriculum simply says that > low-coupon bond exhibits a less negative > convexity. So we may not need to know why in the > exam…IMHO, many MBS related materials are > usually based on empirical study. deriv, exactly what’s been bothering me about the question. Otherwise, the q is really straight forward. I guess we just need to play along with the official line