Assume that interest rates in the year 2010 decrease below historical averages. They continue their downward trend for years 2011 and 2012. In which year would a MBS be least likely to be experience high rates of prepayment? A) 2013. B) 2010. C) 2012. Your answer: A was incorrect. The correct answer was C) 2012. In a mortgage-backed security (MBS), whether a mortgage is called depends on the path of previous interest rates. If rates have been on a downward trend, then fewer mortgages will be refinanced as the trend continues because homeowners that have wanted to refinance will have already done so. Thus fewer mortgages will be refinanced in the year 2012 than in the earlier years.
I thought it should be 2013
C is right
Within the given info I would go for 2013 the only thing that would make me select 2012 is if I was told in 2013 the interest rates dropped so low, so say they go from 10-1 such a change could offset the fact that most people already financed, with such low rates people with bad credit are more likely to qualify to finance since their payments will be much lowers, as well as other things
I chose 2013 too, but then I see that we have no idea what the rates are in 2013…if they drop some 200 Bps, then yes there will be more re-financing. But now that you mentioned this, explain why MBS’s have negative convexity, unlike usual bonds! I don’t know why but I have this in my notes. Anyone knows why?
Dreary Wrote: ------------------------------------------------------- > But now that you mentioned this, explain why MBS’s > have negative convexity, unlike usual bonds! I > don’t know why but I have this in my notes. > Anyone knows why? prepayment risk. you get your money back and that kills your return. pretty sure it’s the same w/ any callable bond. negative convexity around the option strike.
^answered your correct about convexity "I chose 2013 too, but then I see that we have no idea what the rates are in 2013…if they drop some 200 Bps, then yes there will be more re-financing. " In all likelyhood a 200 Bps would not have this effect, I think you would need more than that to offset the fact that most people already refinanced out of this pool… sure their loans will be in other pools now, and they will refinance again, but those people you have left who did not refinance intially probably have bad credit and it would take a big change in the interest rates in order to bring down their monthly payments and make them qualify to refinance… offcourse this is just a subjective opinion, you would neet historical data to answer this… so I still think 2013 is a better choice, since it is unlikely you had a huge drop in 2013… anyway, you will find so many questions in mocks that leave you unsure about the answer, i would not worry about it exam questions will be clear, the point to know is, most people who can refinance will refinance intially and that is called pre-payment burnout, and thats it.
Negative convexity, as I recall, is the fact that a rise in the interest rate leads to a larger drop in price than the rise in price you get if the interest rate drops by the same amount. For normal bonds, it is positve because of the shape of the price curve. How does that fit in with MBS’s?
Agree that negative convexity exists in callable bonds? A calable bond does not get the full gain from a drop in interest rates because if rates drop enough its price would rise and it would be called MBS exibit a similar issue, if rates drop, you would think its a good thing, waw everyone wants to buy my 10% MBS now from me, since the market is paying 8% on new MBS well the problem is soon a lot of people are going to prepay, and whoever owns that 10% MBS is screwed by having to reinvest at 8%, and that works like the call option capping the price
Good answer gulf…got it.
i think youre all reading too much into it. I sent this question into Schweser, they told me to ignore it that there had been lots of questions about it and that the answer is iffy.
Answer should be C.
This is a poorly written question that you won’t see on the exam. Schweser has lots of questions like this that are poorly written. This is more like a gmat logic question than a CFA question. 1. It tells you nothing about interest rates in 2013. Therefore we don’t really want to make any assumption about 2013 and probably shouldn’t choose it. 2. What we do know is that rates decreased (no mention of how much) in 2010 and 2011 and that because its not a huge change there will be prepayment burnout. We can assume that 2010 > 2011 and therefore should choose it.