In CFA 415 summar, it says PO strip benefits from declining interest rates and fast prepayments. Do you agree? I cannot understand how it will get benefitted by fast prepayments.
just remember PO is most afraid of extension risk, so when rates are low they get paid faster PO wants rates low ------- IO is most afraid of contraction risk IO wants rates to be high when rates are low = more prepayments and IO has to reinvest at lower interest rate
Time value of money, if you have a PO whereby you expect to recieve $100 in one year, and instead you recieve that $100 payment in 0.5 years, it’s worth more in PV terms because you are discount the cash flows over a shorter period of time.
Got it. By the way, the text also says that IO security may not realize the amount invested even if the interest rates are held to security if rates fall. How could this be the case? They can lose the original amount even if they held to maturity
If it’s a floating rate IO, and rates drop, less cash is recieved. If i buy an IO that pays me 3M Libor every quarter for 1 year, and I pay $10 for this and LIBOR goes to zero the next day for the remainder of the year, i recieve 0 cash and therefore don’t even realize the $10 i invested.
Thanks a lot