MBS mortgage, positive, following, long

adehbone

the following is from Schweser answer key for volume 2 exam 1 PM question 17.5 -

"MBS, on the other hand, include call options which increase in value with increased interest rate volatility. As long as rates do not fall enough to stimulate refinancing, a small drop in Treasury rates combined with increased volatility will provide positive outcomes for holders of MBS."


i was under the impression that if we own an MBS, the underlying mortgage owners own a call option AGAINST US, not that we own a call option. so i would have thought that increased vol, which increases the option value, would DECREASE the value of the MBS, not increase it.

Help?
Thanks.



Edited 1 time(s). Last edit at Tuesday, June 1, 2010 at 04:36PM by dpcfa.

Zestt

I haven't done this problem yet, but looking at it, it seems that they are talking about a relative increase in value in swapping from corporates to MBS, not just the impact on MBS alone.... There are two effects at work here: 1) interest rates decreasing and 2) increase in volatility. For corporates, effect #1 would lead to a price increase - which would be larger than the MBS would experience due to the negative convexity of the MBS - but the impact of effect #2 would probably hurt corporates more than the MBS as long as the interest rate was still above the point where people would refinance.

ohai

Check the errata. I reported this a couple of week ago.

former

I wonder if that was truly a valid errata. I think they were testing the cuspy mortgage concept....there is a brief area around that rate that the negative convexity wouldn't come in yet.

susana

Ah yes, I see now. I still think they were trying to test cuspy-coupon concept, but screwed that up.

mik82

what is cuspy?