IO strip

You are discounting those future cash flows at the current really high rate.

LanceTX Wrote: ------------------------------------------------------- > Why do IO’s eventually lose value as interest > rates increase? Cash flows aren’t going to change much as interest rates get really high, but the amount, but you are discount those cash flows more.

Yes, but you can also reinvest your monthly cash flows at that high rate… How is that any different than prepayment risk which sucks because you have to reinvest your cash flows at a lower rate than expected?

lance cause as io’s you still have outstanding payments to receive at 5% when now interest rates are 10%

I think you are confusing value with yield to maturity.

florinpop Wrote: ------------------------------------------------------- > lance cause as io’s you still have outstanding > payments to receive at 5% when now interest rates > are 10% Aye, I’m a dummy. Thanks bud

I don’t want to complicate things more but it depends also if you are holding a floating IO, fixed IO, or inverse IO. Generally, if interest rates increase, the lower prepayment rate will allow you to receive more interest for a longer time, and thus the value will increase. The discount rate factor will have an effect but not as much as the actual cash flow.

rates high- prepayment is low that means that there will be a higher outstanding balance - which translates into more interest in present value terms from one point though what you earn in higer payments until maturity you lose by discounting at a higher rate

nattyg Wrote: ------------------------------------------------------- > I don’t want to complicate things more but it > depends also if you are holding a floating IO, > fixed IO, or inverse IO. Generally, if interest > rates increase, the lower prepayment rate will > allow you to receive more interest for a longer > time, and thus the value will increase. The > discount rate factor will have an effect but not > as much as the actual cash flow. That is why the decrease in value is only seen at really high interest rates…no?

IOs fall when interest rates go down, because the principal will be prepaid faster and there will be less interest for the IOs to get. IOs don’t get principal payments, but their interest payments are derived from principal payments. It’s the opposite when interest rates go up, prepayments will decrease, and the interest received will be higher, because there is more interest to get from the principal.

Does schweser/cfa say that the value will decrease when rates are very high? I wouldn’t have thought so to be the case. Typically the discount rate for these things is already high. Around or above 9%, so I really doubt that the value will decrease after a while, but I can’t give you a definitely answer… the effect of the prepayment and the floating rates, if they are floaters, are the major determinates of value, in my opinion…

That’s a question from mock 2 and cfai says it’s true.

hmmm…