Can any one explain me why we cannot tell whethere IO’s value if mortgage rates go above the contract rate. I thought once you get the IO’s you can go and use it at a higher rate so IO’s are more valuable. But the answer was If mortgage rate rises above contract rate, the expected cash flow improves but the cash flow is discounted at a higher rate. The net effect may be a either rise of fall in IO

Take a look at Schweser notes (if you have it) on Book 4 page 250 gives a nice chart. The IO curve slopes up and as mortgage rates increases it gives off a diminishing-marginal return-like-slope and then starts to curve down. As rates increases IO is more valuable b/c of less prepayment, therefore longer interest payment. Eventhough the increased cash flow is discounted at a higher rate, the increase in CF outweights the discount factor. However as the rates increases to a certain point, the discount factor becomes greater than the extra interest payment from the rising interest rates so the net effet may be a rise or fall of IO. If the choice just says “IO will increase in value as interest increases” then it will be incorrect as the statement is not complete. Hmm… I just realized I basically said what you wrote about the answer… hahah hope it helped

This helps…