MBS Sensitivities /2011 GARP Practice Exams L2 E1 Q2

[RomanS]

Hi,

I was wondering if my intuition/reasoning for this GARP practice exam question is right.

Question
Which of the following statement about mortgage-backed securities (MBS) is correct?
i) The price of a MBS is more sensitive to yield curve twists than zero-coupon bonds
ii) When the yield is higher than the coupon rate of a MBS, the MBS behavees similar to corporate bonds as interest rates change.

a) I only
b) II only
c) Both
d) Neither

Correct Answer = c) Both


Intuition/Reasoning
i) Refers to the fact that MBs are similar to coupon paying bonds and that a yield curve twist will affect many cash flows to be discounted differently whereas for the zero coupon bond there is only one cash flows that will be discounted differently. Going a bit deeper into it, like GARP did in its answer, one might explicitly refer to reinvestment risk which is a function positively influenced by time to maturity, coupon rate and call feature.

ii) Is simply checking whether the candidate knows when the call feature is valuable. Since the call feature is valuable when rates are low, a MBS will behave similar to a cbond with comparable duration.

Best Roman

 

[Jiew Kwang]

Hi RomanS,

I kind of agree with your reasoning but i find that part (ii) is ambiguous when they say similar. Taking a look at the bionic turtle notes, the MBS is somewhat slightly more valuable than a corporate bond or non-prepayable pass-through at high interest rates.. But i guess the more significant part of the curve is when interest rates are low and display negative convexity like you mentioned.