Frank Fabpzzi Chapter 1 exhibit 1-10

[Yossarian]

Hi David,

Can you please explain the behavior of MBS versus Fixed maturity bond shown in the Exhbit 1-10 on page no 29 of Handbook of MBS by Fabozzi. I could not understand why the MBS behaves the way explained against the yield.

 

[RomanS]

Hi,
though David might have to add/correct me on this one, the chart simply shows the negative convexity that an MBS bond exhibits due to the prepayment (call) feature.

In other words: an MBS is similar to a bond with comparable duration but in addition sells a call option.

As interest rates fall, it becomes attractive to mortgagors/borrowers to refinance (= prepayment become more likely) and hence borrowers will tend to make use of their call feature, i.e. paying off the current loan with a ne loan which has a lower mortgage rate than the old loan.

Best Roman

 

[David Harper CFA FRM]

Hi Yossarian,

I agree with Roman.

The same concept (pass thru MBS versus plain noncallable) is reviewed more thoroughly in the Tuckman chapter on MBS. Here is our post on that graphic: http://www.bionicturtle.com/how-to/article/negative-convexity-valuation/

Tuckman explores three dynamics (versus the noncallable), far as i can tell:

1. a mathematical (optimal) dynamic: as Roman shows, the call option (prepayment) that would "bend the curve" toward par value at low yields
2. a reality-based (non-optimal) nuance: it doesn't bend all the way to par, as homeowner's do not prepay with perfect efficiency
so (1) and (2) refer to the dynamic at low-yields: negative convexity but not bending perfectly to par due to reality-based inefficiencies of "option holders"

3. at high yields, another reality-based dynamic: note the call option would not be optimally exercised at high yields, so in pure math, the MBS curve would not differ by much. Rather, inefficiently, homeowners call due to turnover even when financially suboptimal. This explains why the MBS line is higher at higher yields; investors benefit from the occasion sub optimal prepayments

David