i am confused by my own notes… how to reconcile these two relationships?? is the spread actually negative? (that wouldn’t make any sense)…
any help greatly appreciated, thx!
MBS Yield = Treasury interest + spread
Agency MBS = Treasury Security – Prepayment Option (this equation was used to explain why MBS had negative convexity, when interest rates dec, treasury inc, but prepayment option also increased, making MBS increase less than treasury)
Yield will be higher since you will require a higher compensation for the short call option you got with a MBS
Higher yield mean lower price, which would be in line with MBS = Treasurie - prepayment option
If you own an MBS then you’re short the prepayment option (it’s owned by the issuer). Because the issuer owns that option, they have to pay for it; the spread you earn includes the amount the issuer pays for that option.
Remember that the option value = Z-spread – OAS: for MBSs, OAS < Z-spread, so option value > 0: extra basis points of return to the bondholder.
brilliant - thank you both!
My pleasure.