If interest rates fall, prepayment increases, PO structure gets paid earlier, value of PO gets larger due to smaller discount rate applied, i.e., price of PO goes up. But for an IO structure, as interst rates go down, prepayments increase, value of IO increases because of smaller discount rate (just like with PO), but the price of te IO goes down, not up. Why? Is it because, with the PO there are still large pincipla payments coming up in the future, which are worth more than before as interest rates go down? But for an IO structure, future interest payments are smaller (they decrease over time), so the IO is worth less going forward…i.e., fewer dolars remaining?
IO I think the key point is that IO Owners expect to get their amount back over a longer period of time. Once Interest Rates fall - there is a high chance that the entire mortgage might get refinanced - so there is no more principal, hence no interest at all. They have suddenly lost all the amount they were expecting to get. High Contraction Risk for the IO portion.
There was a question on the CFAI mock related to this - can’t remember if it was AM or PM version, but it (from what I recall) directly contradicted what Schweser had been teaching about IOs. Can anyone help me out here?
Right, cpk, I think this is the point. If you buy a PO structure, principal repayments get larger over time, so if interest rates go down, principal gets paid off quickly, so you get your money back faster, leading to a higher rate of return… i.e., you paid $400k expecting to get paid $500k in 3 years, but now you are looking at getting it back sooner, thus a higher price for the PO (these are discount loans). With IO, interest payments are based on outstanding principal. With prepayments picking up, the principal shrinks fast, and the interest you get is reduced, thus price of IO goes down.
Haven’t taken the CFA mock’s yet, but here are my thoughts: P/O - Lets say these are purchased at a price that assumes your principal will be paid back over 10 years. Interest rates drop, people refinance and suddenly you get all of your payment much more quickly, lets say in like 2 years. Just based on time value of money, this would increase the value as you get all of your payment in 2 years rather than 10. If rates were to increase, less refinancing, the principal is paid back slower, so now you are receiving the same nominal amount, but spread over say 12 years instead of 10. Value goes down. I/O - kind of the opposite of regular bonds. Interest rates drop, everyone refinances and all of a sudden, where you thought you would be receiving regular interest over a 10 year period, all the principal that your payments are based off of gets paid off and you’ve only received interest over a 2 year period - moreover, the rate that you can reinvest those payments at is also lower. So, value goes down. Now, if rates increase, no one refinances and instead of getting payments for only 10 years (like you initially projected) you get payments over 12 years, so more payments. Also, you can re-invest those payments at the higher current market rates, so more upward pressure on value.
You got it Chi Paul. Haven’t taken the mock either, my question is general.
what is difference between value annd price of io
Alimesoda, If you are referring to my post, I was using them synonymously.
yes thanks
ignore my original post. In general though, value is what it is supposed to be worth, and price is what it is actually selling for.
Value of IO can decrease if the change in discount rate is less than the change in your CF yield. For all intensive purposes, the value of IO can either go up or down, depending on the “strength” of the CF yield vs interest rates.