Can you guys explain why PO strips have negative key rate durations in the short term while interest only strips start out with positive key rate durations? Thanks!
An IO strip is a bond and if the mortgages were not prepayable it would behave just like any other bond with positive key rate durations all along the yield curve. Alas, mortgages are prepayable and that means that IO strips have negative effective durations. This is because when interest rates drop, people refinance and the total amount of cash paid to the IO holder drops. The decreased cash flow trumps the decreased discount rate every time. Key rate durations measure the sensitivity at points along the yield curve. We use them for assessing non-parallel shifts in the curve. Imagine that you own IO strips and the <= 1 year rates drop but other rates stay the same. This is good for you, because you own a bond and interest rates dropped. A drop in <= 1 year interest rates does nothing to the refinance rate because it does not affect mortgage rates. However, out around (uh, I don’t really know) 7 years or so the drop in interest rates will cause people to refinance so the krd becomes negative. PO strips with negative key rate durations…Hmmm… Edit: I don’t think a PO strip has any negative key rate durations.
They do according to Schweser Book 3 pg 112. "Principal-only strips have negative key rate durations in the short and intermediate rates, which turn positive for longer rates (eg 10 year).
the cfai text has a graph that displays -ve durations for PO as well.
I think it’s just wrong. I can’t think of any reason why a PO strip would have any negative krd’s. I think a PO strip has similar krd to the underlying pool at short maturities and much higher krd’s at high maturities.
Have to agree with JDV here, sometimes CFAI is talking out of their a** without explaining why it would be so. If everything else is held constant - key rate duration should be positive.
We need someone who has actually traded a mortgage derivative on board. CSK - have you ever traded one? (I haven’t).
I asked my friend who works with MBS, i will let you guys know if i hear anything
PO has negative key rate duration in the short and intermediate term and turn to positive key rate duration in the longer term. which because when yield falls, people hold MBS more like to refinance, and prepay the principle, which caused PO MBS value underperform compared to bullet bond, but for older PO MBS, the MBS holder may not refinace due to the less loan left at the end. when yiled increase the PO will perform the same as bullet bond. IO start with postive key rate duration and turn to negative. because for new issued IO, if the yield decrease, the MBS holder finance, and the IO vaue based on the interest income according to the principle balance, so the IO value falls, however, the yield increase, the IO value increase due to the higher loan balance. for the longer term IO MBS people unlikely refinance even if the key rate change due to the less mortgage loan. Negative rate duration implies the MBS value changes the same direction as the changes in key rate (interest).
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the above explaination combine the Schweser MBS (yiled cureve risk) and CFAI curriculum.
Do you know what key rate duration means?
They are indeed negative, but I have only confirmed this through the our FI analytics software. If you were to graph the KRDs, the positive values which are located near the maturity date significantly outweigh the negative krds at the shorter buckets. I’m talking like -.1 KRD1 vs. 13 KRD10 for one particular PO.
Why is it negative?
Joey, if I knew, you would be the first person I would tell… In reality I don’t know the answer (the MBS PMs here probably wouldn’t know either). All I am doing is pointing to the way citi models their zeros coupon bonds. I know it’s not adding much…
OK - I’m on a mission to find out.
Hmm… Found this: http://books.google.com/books?id=S4YGyb506wMC&pg=PA172&lpg=PA172&dq=“key+rate+duration”+po+mbs&source=web&ots=ZxhN754OYw&sig=KK5y-DoFHK1zWgiAy7Ro0_nPDc8&hl=en#PPA172,M1 So it’s from Thomas Ho (really smart guy). They also credit Donald Chambers who is my mentor and friend, so I’ll talk to him this evening and see if he knows (he won’t, but always good to talk to Uncle Donnie).
Joey did you get the chance to talk to the guy?
Oops. Will do. Sorry.
baocarol Wrote: ------------------------------------------------------- > PO has negative key rate duration in the short and > intermediate term and turn to positive key rate > duration in the longer term. which because when > yield falls, people hold MBS more like to > refinance, and prepay the principle, which caused > PO MBS value underperform compared to bullet bond, > but for older PO MBS, the MBS holder may not > refinace due to the less loan left at the end. > when yiled increase the PO will perform the same > as bullet bond. > I thought PO acts like discount bonds, you buy them 90, 95 cents on the dollar. Therefore, I would think when rate drops, people are more likely to refi, therefore principle gets returned faster. Therefore, we can observe a price increase in PO. That is still positive key rate duration.