Prepayment risk refers to contraction risk and extension risk. I don’t understand why in sequential-pay tranches the first to mature tranche offers relatively more protection against *extension* risk. I would say it offers some protection against *prepayment* risk (i.e. both extension and contraction) - just because the term is shorter there is more visibility on the risk. Could you help me there?
Extension risk is the risk that your MBS will drag on forever. The first to mature tranche will get all the prepayments so it won’t drag on forever.
Try to think about it in terms of up and down interest rate scenarios. Lets say we’re in a up rate environment. Even though prepayments will likely slow down, the tranche will still experience some prepayments. So even in an up rate environment when fewer prepayments are realized, all prepayments are still applied to the first tranche. Any other thoughts?
Right ^. People will still pay off mortgages to move to other cities etc, even when IR are up.
Thanks for your posts but… I still don’t get it… Somehow what I have difficulties to understand is this “asymetry”. Let me explain. Contraction risk is the opposite of extension risk. One is “+” the other is “-” but that is the “same variable”. I would say why the sensitivity to that variable is higher when the variable is negative than when the variable is positive ? If we say we have two tranches one is reimbursed faster if prepayments are higher than anticipated and the other is reimbursed slowlier if prepayments are lower than anticipated, we break the symetry and then one tranche has the prepayment risk, the other has the extension risk. But in sequential pay tranches, why the symetry would be broken? This is what I don’t understand…
extension risk protection on senior tranches is provided by allocating more prepayment in early stage. Therefore, in cases of increasing interest risk later on, the holder of senior tranches will have more money in hand to capture the better reinvestment opportunities regardless the slowing-down prepayment. I hope it helps…
Absolutely, it helps! I can see now where the asymetry comes from. Thanks!