risks of prepayment are… a. contraction risk - when the int rates fall, prepayments rise n expected life of the mortgage pool contracts. under this …they also say…mbs exhibits a negative convexity. some 1 please explain this negative convexity shown by mbs when the int rates fall(ie, contraction risk) ???
the prepayments increase at a decreasing rate over time i.e. most prepays are done immeditaley following the drop and slowly others prepay during the duration of the contraction period…hope that helps
This is similar to the convexity of a callable bond. As int rates fall more borrowers pay off their current loans early by refinancing which causes contraction risk in the underlying MBS and therefore their value begins to decline. If you imagine the graph that shows negative convexity it kind of looks like a slide. Int rate on the x axis and price on the y. If you buy a MBS with an int rate of say 7%, once int rates fall to 6.5% that 7% int rate looks pretty nice to other investors so they bid up the price to buy it! At this point the current int rate has gone down, but the price of your MBS has increased(like any bond) Now imagine that the int rate falls to 4.5%. at this point the underlying mortgage holders paying 7% on their mortgages decide to refi. and lock in a better rate. this causes the MBS principle to decrease, which means that even though you are still receiving 7%, it is on less principle - so your return is going to be less than what you originally expected. Lower return means other people don’t want to pay as much for it! So with these two examples you can see that when the int rate falls a little, the price of the MBS increases, but once the Int rate falls enough to intice people to start to refinance the price of the MBS increases at a lower and lower rate and will eventually drop if the int rates fall to a point where enough people refi. to cause this. Ergo, negative convexity. for more information on negative convexity, please refer to your level I books…
What is so bad about negative convexity? Basically a restriction on upward price potential of a bond?