On page 61 Schweser book 3, it says that callable bonds will outperform noncallables when rates increase (at lower rates) bc they respond less to the rate change and therefore prices decrease less. However, on page 118, it says how the callable bond would decrease $120,000 when the hedge position (noncallable) only decreases $80k when rates increase. Doesn’t this contradict page 61?
isnt this saying that callables will underperform (decrease more in value) when rates increase?
A couple of notes:
This is a different situation from that described on p. 61. I don’t believe that they’re contradictory.
So when compared to the treasury which is used as the underlying asset in the hedge for an MBS, the MBS suffers from a lose-lose situation? That is, when rates decrease they gain less and when rates rise, the MBS suffers by losing more value than the treasury?
However page 61 is a different scenario comparing callable and noncallables, in which case it’s not lose-lose for the callable. They gain less when rates decrease (lose) but also decrease less when rates rise (gain).
I guess I just thought of a callable to be like an MBS and a noncallable to apply to a treasury, but that’s not the case?
Is that not confusing
It isn’t so much that it’s not the case as it is that on p. 118 you’re comparing two very different bonds: an MBS and a Treasury.
It shouldn’t be: on p. 118 we’re comparing two very different bonds. That they don’t behave like to generally similar bonds shouldn’t be a surprise.
So then in summary:
1). When rates are low, a callable bond will underperform against a noncallable bond when rates fall but outperform when rates rise (decline less in value), correct?
2). When discussing MBS and hedging (and rates less than the coupon), an MBS will gain less when rates fall compared to the treasury and lose more when rates increase, correct?
Yup.
The way I understand it, whenever interest rates fall, people tend to prepay their mortgages faster, thereby reducing an overall gain (a slower increase in price) of an MBS. And vice versa, when interest rates increase, the prepayments slow down, making the fall in the price slower. The prepayment risk decreases the duration of the MBS. It is less sensitive to the yield changes than a government security. MBS does have a callable feature (option to prepay), so at the lower level of interest rates, the duration of MBS should be close to that of a callable bond.
am i confused?
Thank you S2!
Sounds good to me.
Awesome! Thanks for the confirmation.
On a side note, why don’t they call it concavity, instead of negative convexity?
These terms are interchangeable… so there is really no difference which terminology to use =)