On schewser notes study session 15 page 291 it says: Tranches trading at a premium (discount) will see gains (loses) when the assumed prepayment rate decreases.
i can’t seem to understand this, can anyone explain?
If the tranche is trading at a premium, _ its coupon rate is higher than its YTM _. If the prepayment rate decreases, then the maturity increases, and you earn higher-than-market rates for a longer period of time: the value of the tranche increases.
If the tranche is trading at a discount, _ its coupon rate is lower than its YTM _. If the prepayment rate decreases, then the maturity increases, and you earn lower-than-market rates for a longer period of time: the value of the tranche decreases.
You can see this easily in straight bonds: when YTM = 5%, a 5-year, semiannual-pay, 6%-coupon, $1,000 par bond sells at $1,044; a 10-year, semiannual-pay, 6%-coupon, $1,000 par bond sells at $1,078. Above-market returns for longer lead to higher prices.
Similarly, when YTM = 5%, a 5-year, semiannual-pay, 4%-coupon, $1,000 par bond sells at $956; a 10-year, semiannual-pay, 4%-coupon, $1,000 par bond sells at $922. Below-market returns for longer lead to lower prices.
Thanks again. You just put it in a way it’s so much easier to be understood
You’re welcome.
That’s always my objective. It’s nice to succeed once in a while.
yeah, well done. I understood this…but wouldn’t have been able to articulate as clearly.
Lol when u r a charter holder, u will be haha
haha true.
Please tell whether OAS considers prepayment risk >
It doesn’t.
OAS is option-adjusted spread: all of the options (prepayment, call, put, conversion, cap, floor, accelerated sinking fund, etc.) are removed.
s20000 u r a true magician please help us till exam
I think the OAS does consider the prepayment risk. The OAS is the MBS spread after the “optionality” of the cash flows is taken into account.
Anyone?
OAS is the MBS spread after the optionality is _ removed _, not after it is taken into account.
Z-spread takes the optionality into account.