Anybody has a clear idea about IO & PO relation to increasing and decreasing mortgage interest rates?? Thank you, Anish
PO’s have very high durations and when mortgage rates come down, people pay-off their mortgages, the PO’s get paid money they might have gotten in 30 years but instead get today. The PO’s are happy. The IO’s get a little boost when rates come down a lttle because they are bond owners too. But then everyone starts to refinance, and that money the IO’s though they were going to get in 30 years, they’re not getting it at all. The IO’s are very sad.
Thanks for the response. I understand your point on PO’s but for IO’s schweser mentions that in some cases “…there is a range above the contract rate for which the price increases.” My concern is does the price of an IO always increase with increased interest rate or only upto certain limit? Thanks again Anish
As functions of interest rates: IO increases up to a point and then starts declining PO is always decreasing
Both POs and IOs are referenced using the contract mortgage rate. If rates fall below the contract rate for POs, then prepayments speed-up and the price of the PO rises. If rates move above the contract rate, prepayments slow down and the price declines. For IOs. If the rate rises above the contract rate, then the IOs increase in value. If rates, go below, then IOs decrease in value. Based on the diagram provided in the CFAI text, it looks like the price of IOs does level at some point (and even decline a little) if rates keep moving higher, but there is no commentary explaining why that is.
Could that be due to principle repayment… the more principle repaid the less interest earned as time goes by
I think that is quite possible…as you say, as time goes by.
FastEd Wrote: ------------------------------------------------------- > For IOs. If the rate rises above the contract > rate, then the IOs increase in value. If rates, > go below, then IOs decrease in value. As rates go up, prepayments will decrease. At some point, there will be virtually no more prepayment. But then, you alos have a second effect. That is, as interest rate increase, the discount factor you’ll use to compute the PV of future cash flows will also increase. Greater discount factor => Lower PV
That makes alot of sense olivier. Thanks.