Schw Vol.2 Exam, 2PM Q#16.1

Why is choice “B” incorrect? It says, “The mortgage position has negative exposure to duration at low yields.” Doesn’t that simply mean that the bond is exhibiting negative convexity?

bump. anyone take this?

No, the conxexity shifts in mtg securities. At low yields, the mortgage is In The Money and so for every additional unit rates decrease the market value of the mortage security increases by a decreasing rate (negatively convex). However, when rates are very high the mortgage is way out of the money and hence, the option value is zero and so moves like a straight bond (i.e. Straight bonds have positive convexity)

AFJunkie Wrote: ------------------------------------------------------- > No, the conxexity shifts in mtg securities. At low > yields, the mortgage is In The Money and so for > every additional unit rates decrease the market > value of the mortage security increases by a > decreasing rate (negatively convex). However, when > rates are very high the mortgage is way out of the > money and hence, the option value is zero and so > moves like a straight bond (i.e. Straight bonds > have positive convexity) Oh so do you mean that we’re looking at this thing from the perspective of the option holder (the mortgage owner)? So the exposure is actually positive, not negative, from option holder’s perspective?

You mean exposure to interest rates? and by positive do you mean positive convexity? I dont follow…

i guess i don’t really understand your explanation in terms of why the following statement is incorrect: “The mortgage position has negative exposure to duration at low yields.” Isn’t this a true statement, and isn’t this another way of defining negative convexity? Maybe instead you could explain what the statement means? Maybe I’m not reading it right.

Okay…i understand what you are asking and I think I can answer your question. Negative exposure to Duration means that for a decrease in interest rates you loose money, and for an increase in rates you make money. In the problem the mortgage is loosing money when rates increase. So it has positive exposure to duration. Thats why B is wrong.

hmmm. when you talk about the effects of positive/negative exposure to duration on bond value are you talking about what happens with PO and IO strips? For example, the PO strip’s negative key rate duration means that when rates go down, prices go down (rather than up, like it would have in positive duration scenario)?? If so, then I don’t think that’s what the question is asking. If not, then I still don’t get what you’re saying.