when interests rates drop, prepayment increases, causing repayments to accelerate. i understand that the dollars to be received are held constant and the amount of time is shortened, which can be balanced by reducing the discount rate. why does the PO price rise in turn?
Because if interest rates drop enough, principal you were scheduled to get in 30 yrs comes to you tomorrow.
just think time value of money, the initial price assumes that it takes x amount of time to get your principal. lets say it takes 30 years to get all of your money. now, you are getting your money back a lot sooner, so you are getting the same cash flows but sooner, so that has to push up the price. whats worth more, a zero coupon bond with the principal in 1 year or 10 years?
since the PO pv is a function of prepayments, how is the forecasted prepayment speed determined? via the SMM or BMA benchmark?
mike0021 Wrote: ------------------------------------------------------- > just think time value of money, the initial price > assumes that it takes x amount of time to get your > principal. lets say it takes 30 years to get all > of your money. now, you are getting your money > back a lot sooner, so you are getting the same > cash flows but sooner, so that has to push up the > price. > > whats worth more, a zero coupon bond with the > principal in 1 year or 10 years? thanks.
usually a prepayment model. the bank i work for has an in-house model, and if you run interest rate shocks on a PO strip, when rates drop, the weighted average life decreases, your cash comes in faster, and the price rises towards par. if you just use the same PSA then it doesnt matter what rates do, although that would be pretty inaccurate. i just ran a PO strip priced at $74. i shocked rates up +/- 100bp, and it looks like this: Shock: -100 0 +100 PSA 292 179 150 WAL: 2.3 6.8 8.9 PriceL 88.6 74.4 64.3