hi, can you please explain why it is undesirable for passthrough investors when interest rates fall and the security exhibits negative convexity, meaning that the oppotunity for gains when rates fall is taken away… thanks
higher level of prepayments that you have to reinvest at low rates
so that would be the meaning of negative convexity?
If interest rates fall, investors are going to prepay off their outstanding loans and refinance. This prepayment is risk for those holding the pass through. They are no longer getting their desired interest rate though the security and if they have to go back in the market to get that rate, will be lower. The right to call (from the home owners perspective), is a disadvantage for the MBS holder and is comparable to negative convexity on a call option with a bond. Does that help?
i think there is more to it because the reply you gave me is another undesirable consequence. I am referring to question bank no 23462…
chart similar to callable bond -> when interest rates go down by 1% the price doesn’t go up as much as it goes down when interest rates go up by 1%
hmmm not sure how to try and explain. Prices of MBS can only go so high because of the call option provision. This call option causes negative convexity. At some point people are going to refinance at the lower rate and bail on current mortgage. You can see the negative convexity in the graph.
ok understood thanks. taking it like a callable bond there is limit on how much the price can go up so - negative convexity
You got it. I think maratikus gave the perfect technical answer. I was trying to word it that well but fell short.