Hi everyone could I please get some help with the following CFAI Answer: -
“All MPS Exhibit negative convexity. However, low-coupon issues exhibit less negative convexity than high-coupon issues. That is, there will be greater price appreciation for low-coupn issues when rates decline.”
Why is this?
Thanks in advance.
MBS exhibits negative convexity due to refinancing done by the borrowers when Interest rates decline. If I am paying high coupon rate, there is a high chance that I may redeem the security and refinance it with lower rates. It is less likely for a low coupon payer to refinance.
“All MBS Exhibit negative convexity” - There will be prepayments when interest rates decline.
“However, low-coupon issues exhibit less negative convexity than high-coupon issues” - If you are already on low rates on mortgages, there is a lower probability / incentive for prepayments (which are passed through to note holder).
End result - There will be greater price appreciation for low-coupn issues when rates decline. In declining Interest rate environment you will prefer to hold low-coupon issues.
@rockmania and @zulu007 thanks for clearing that up! Definitely popped back into my head as I knew this for L2 
Btw how did you both find the R2 CFAI questions?