when a pac is set up w/ an initial pac collar, in order for the investor to be able to realize the average life the psa must be w/ in the initial pac collar. i understand that. but here is where i get confused if the psa in w/in the collar but the psa fluctuates the investor might be expsed to some contraction/ extension risk. why?? i thought that as long as the psa was with in the collar everything was ok. so does the psa have to be 1-within the collar and 2 steady with in the collar…?
If it is within the collar everything is OK for the other tranche. But as it fluctuates and nears the edge of the collar, the risk characteristics change because it is more or less likely to exceed the collar. So the other tranche is more likely to face prepayment or extension risk as the psa gets closer to being outside of the collar. Am I thinking about it right?
then the psa must be with in the collar and constant in order for the pac to maintain… so if the psa is not constant, the collar changes and we need to concern ourselves with the effective collar. got it now…
As long as the prepayments stay within the collar you will get no extension or contraction. As prepayments fluctuate, you get extension and contraction risk, just like you have default risk in a bond that is doing fine paying its coupons, etc…
so they can fluctuate w/ in the collar and you are still ok?
i am getting spun around… i fell like buy, sell. buy, …shit i sold…
Distinguish in your mind between contraction/extension and contraction risk/extension risk. If the psa fluctuates in the collar, contraction and extension RISK changes. If the psa goes outside of the collar, contraction or extension changes.
nikko0355 Wrote: ------------------------------------------------------- > so they can fluctuate w/ in the collar and you are > still ok? No
It’s like what happens to a bond when the company announces massive lay-offs and tells the union they need concessions or else. Your bond doesn’t default but nothing good is happening to its price. If PAC prepayment is hanging right inside the collar, everyone is thinking that it’s going to be busted soon. With a TAC bond you can think that you are short out-of-the-money prepayment options and so vol directly hurts your option position. It’s a little rougher to get that to work with PAC bonds I think. Maybe maratikus can work it out for us.
nikko0355 Wrote: ------------------------------------------------------- > so they can fluctuate w/ in the collar and you are > still ok? It depends on what the effective collar is at a given point in time. This can be differrent from the intial collar. As long as you are flucating within the effectve collar you are good. the effective collar is determined by, how the prepayments have been so far. large number of pre payements would weaken the support tranche and the effective collar would shrink.
They don’t fluctuate when its in the collar. But, while its is fluctuating in the collar and the effect of that is being borne by the support tranche(s) and if the support tranche(s) get paid off due to the hit they took of the fluctuation in the pac collar then the next time there is fluctuation, there is no tranche to support the pac and so the pac can have extension or contraction risk. I think there is a sentence explaining something to this effect in the support tranche section in Schweser notes (don’t have them in front of them so can’t cite exactly where) – something like the size of the support tranche determines the stability of the pac tranche.