prepayment is with relation to principal, not with respect to coupon payments - right?
Yes prepayment has contraction and extension risk. Contraction risk is the negative consequences from a decrease in interest rates (I think of it as interest rates decrease, more refinances, more prepayments). You have to reinvest the increased capital at a lower rate. Extension risk is the negative consequences of increase in interest rates (fewer refinancing which means you are not getting as much capital back to reinvest at the higher rates).
You buy the PO strip at a discount b/c you only receive the Principle portion of the mortgage pmts. Say if you have a PO strip worth 50mill in principle: If you sell it at 50mill the return on investment would be 0% - who would buy that? you would have no chance of making any money. you would actually lose money due to defaults and Inflation. However, if you sell it at say 30mill the investor has a chance to get a return from it. How much return depends on the length of time it takes for the principle to be paid back. assuming no defaults and all principle is paid back in 1 year you receive 20mill/30mill or 66.67% return. the longer it takes and the more defaults there are reduces the return to the investor. If principle is paid over 2 years and assuming 10% default rate you receive [1+(20 - 5)/30]^.5 = 22.47% ave annual return. Contraction risk would not be a concern of PO investors b/c they actually want to be paid faster; however, contraction risk is present b/c the longer it takes for them to get paid the lower their ave. annual return.
FinNinja is correct all except for the last paragraph. (Good example btw) Contraction risk is what PO’s want. Investors want the MBS pool to ‘contract’ and prepayments to rise as rates drop. Extension risk is what IO’s want. Investors want the MBS pool to ‘extend’ and carry a long life. They like rising interest rates and decreasing prepayments. On a side note, what if you had purchased MBS PO Strips 1 1/2 years ago when Fannie Mae and Freddie Mac came out with the 125% LTV refinance program? That would’ve been HOT! I know a hedge fund manager who did…
FinNinja , base case for the PO investor is when things are humming along as designed with prepayments at the expected level , and the PO gets paid off at a planned rate. When rates fall , PO investors enjoy the benefits of loan contraction… Do not double read this to say they “contraction risk” is present . There is NO contraction risk to the PO investor. To the PO investor, there is only EXTENSION risk , which is that their investment pays off slower than originally planned due to rising interest rates , making the issuers slow down on pre-payments . Risk is measured only to the downside . If the PO investor is in good times , with rates falling and pre-payments rising , that is a good thing to them , not a risk thing.
You guys are right, the last sentance was supposed to read: “Contraction risk would not be a concern of PO investors b/c they actually want to be paid faster; however, EXTENTION risk is present b/c the longer it takes for them to get paid the lower their ave. annual return.” Whoops, I always end up typing faster than I think. This next part may open a whole new can of worms but… I do believe that there is a contraction risk, risk being measured by variability of returns. however this can only be a good thing for investors - it would basically be an upside only risk measure - which is odd b/c investors are generally more focused on what risk to the downsid would be. One reason I think that this exists is b/c you can have a total risk measure AND a downside risk measure - these are generally different from each other, which leads me to believe there is an upside “risk” measure as well. I don’t have my book with me or I would look to see if ti specifically says there is NOT a contraction risk to PO investors or if it just states that PO investors are not worried about contraction risk. Either way it is a small point, but one I could see CFAI structuring a question on. as we all know CFAI can be very picky about word choices. Does anyone have this book to look up the answer?