2 questions regarding MBS. 1. Will the Par Value of a MBS be at its C/R (coupon rate), just as other bonds ? 2. Will MBS exhibit negative duration if I/R declines immediately below the C/R or only if I/R declines substantially below the C/R ? Converesly, will MBS exhibit positive duration if I/R rises immediately above the C/R or only if I/R rises substantially above the C/R ?
- theoretically yes 2) immediately below/above
- Yes 2) You are talking about a cuspy and it will depend on the coupon rate. The higher the coupon rate, the higher the chances of immediate negative convexity. It will not be the same if the coupon is already low. You also need to incorporate interest rate paths. If interest rates had dropped before in the past, investors that have the capacity may have refinanced and if rates go back and then down again, the negative convexity may not be so prominent.
My 1st question : I am asking this because I know that the intermediary charge some spread between the rate paid by the borrower & the rate received by the MBS holder. My 2nd question : Yes, I am talking about the cuspy-coupon MBS. I now understand that if interest rates had once dropped in the past, borrower/homeowners (rather than investors, right ?) may have refinanced and if rates go back high and then come down again, the negative convexity may not be so prominent. By the way, regarding “cuspy-coupon MBS”, what does it mean by “cuspy” ? And what does it mean by “be prepaid” in the 1st paragraph under the title of “HEDGING CUSPY-COUPON MORTGAGE SECURITIES” on P.183 of CFAI Text Vol 4 ? Is the “Current coupon” the higher rate and is the “Cuspy copon” the lower rate mentioned by you ? Sorry for so many questions !
Question 1: The intermediary does not have any business with the principal payments. They get their payments from a “spread”. If the mortgage pays 8%, the intermediary may pass along 7% to the investors while keeping 0.75% and transferring 0.25% for other admin stuff (legal, marketing, auditors, etc). Question 2: Cuspy comes from the word “cusp”, like the edge. If the mortgage rate is high and general interest rates are at the same levels, there will be no prepayment meaning the MBS is just “at the edge”. A little drop in rates will lead to a flurry of prepayment meaning that the MBS will be “prepaid”. The cuspy coupon is the current coupon. If rates drop the borrowers will have access to loans at lower rates and will “prepay” the MBS very quickly especially if the coupon rate is high.
me.tega, Thank you for your further explanations. But can you advise what is meant is by the statements of “A mortagage security whose coupon is 100 basis points higher than the “current coupon” could be prepaid slowly if rates rise by 25 basis points but prepaid very quickly if rates fall by 25 basis points” in the 1st paragraph under the title of “HEDGING CUSPY-COUPON MORTGAGE SECURITIES” on P.183 of CFAI Text Vol 4 ? In Exhibit 6, is the “Current coupon” the higher rate and is the “Cuspy copon” the lower rate mentioned by you ? Thanks again !
alta168 Wrote: ------------------------------------------------------- > me.tega, > Thank you for your further explanations. > > But can you advise what is meant is by the > statements of “A mortagage security whose coupon > is 100 basis points higher than the “current > coupon” could be prepaid slowly if rates rise by > 25 basis points but prepaid very quickly if rates > fall by 25 basis points” in the 1st paragraph > under the title of “HEDGING CUSPY-COUPON MORTGAGE > SECURITIES” on P.183 of CFAI Text Vol 4 ? > > In Exhibit 6, is the “Current coupon” the higher > rate and is the “Cuspy copon” the lower rate > mentioned by you ? > > Thanks again ! I have no clue what you mean by current coupon and cuspy coupons, since cuspy coupon is referring to a specific type of MBS. That is, one whose coupon is close to or at the current interest rate. If interest rates are at 5.5% and your MBS has a coupon of 5.5%, a 25bps move downward move in interest rates would cause prepayments to accelerate. Going 25bps in the other direction would yield no change in prepayments, or even a decrease.
bpdulog Wrote: ------------------------------------------------------- > I have no clue what you mean by current coupon and > cuspy coupons, since cuspy coupon is referring to > a specific type of MBS. That is, one whose coupon > is close to or at the current interest rate. Please refer to Exhibit 6 on P.183 of CFAI Text Vol 4.
alta168 Wrote: ------------------------------------------------------- > bpdulog Wrote: > -------------------------------------------------- > ----- > > I have no clue what you mean by current coupon > and > > cuspy coupons, since cuspy coupon is referring > to > > a specific type of MBS. That is, one whose > coupon > > is close to or at the current interest rate. > > Please refer to Exhibit 6 on P.183 of CFAI Text > Vol 4. I’m looking at it, it’s just a graph. The tangent of the line underneath where it says cuspy coupon is the coupon rate of the MBS.