Does this apply to MBS or is this more important with bullet structures ? Can someone clarify ?
Negative convexity applies to MBS. Positive convexity applies to bonds with no embedded options in them.
thanks BB, but should both perform the same when interest rates rise ?
all normal bonds exhibit degrees of positive convexity, since duration doesn’t account for 100% of changes in bond prices (they aren’t linear). MBS in particular exhibit negative convexity, as do callable corps.
actually, callable bonds perform more when rates rise. this is because the option gets less valuable as rates rise
MBS securities and bonds with embedded call options have negative convexity below the coupon / passthrough rate. The bonds won’t fully participate from the gains when rates drop below their coupon rates because debtors will have incentive to call the issues and refinance. At high interest rates, there is no incentive to refinance so the bonds will have positive convexity. Bullet structures will always have positive convexity (some more positive than others).
depends. if the market rate is below the coupon rate then as rates rise the price of the positive convexity instrument will fall faster than the negative convexity instrument. same as when rates fall, the price of the positive convexity instrument will increase faster because there is no option in there to limit price appreciation. once market rates get out past the coupon rate the two pretty much behave the same. Edit…a good excersise for this is to get a graph showing an overlay of a positive and negative convexity bond…if you follow my logic through the picture it makes total sense.
cfa09 Wrote: ------------------------------------------------------- > should both perform the same when > interest rates rise ? I think this is correct. As I/R rises and your prepayment risk decreases, the MBS should act just similar to a non-callable - as the option value decreases, the price falls in line with that of a noncallable.
at very high rates, MBS act just like non-callable bonds. however at increasing rates, within reason over the coupon, MBS will outperform. think of this: Vcallable = Vnoncall - call option
Big Babbu Wrote: ------------------------------------------------------- > Edit…a good excersise for this is to get a > graph showing an overlay of a positive and > negative convexity bond…if you follow my logic > through the picture it makes total sense. As BB said, you can really work through ANY of these conceptual duration / convexity problems by just picturing the graph of a bond’s interest rate sensitivity.
Kroch, you’re bringing out L2 material on me!
and vice versa for puttable bonds: Vputtable = Vnonputt + put option at very very low rates, the put is not worth much, so will perform like non puttable. at high rates, put worth a lot, so outperforms regular bond i think this is right, but its getting late…so apology in advance!
dpak- i work in fixed income for one :)—though never see puts. we have a portfolio of callable bonds, so i know them well. also, this is all game on the exam and covered in fixed income SSs. as others have said, helps to draw the picture.
I know - they can test any nook and cranny of the material. Its amazing how much Ive forgotten since L2.
LOL…I was just lurking through the level 2 board earlier tonight and was saying to myself how much I’ve forgotten of that stuff. Especially the accounting…i would get absolutely throtled on that crap.
i think i’d rather have translation acctg than IPS for an exam, but hopefully I am proven wrong 
Agreed. I remember putting in alot of hours to get that translation stuff down, but it wasn’t subjective like this IPS stuff.
The accounting stuff is easy once you get the rules down. Very black and white. It just sucked to read all that crap.