Reading 59: Valuing Mortgage-Backed and Asset-Backed Securit 2011, describe, measures, center, market

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Session 15: Fixed Income: Structured Securities
Reading 59: Valuing Mortgage-Backed and Asset-Backed Securities

LOS h: Explain other measures of duration used by practitioners in the mortgage-backed market (e.g., cash flow duration, coupon curve duration, and empirical duration), and describe the limitations of these duration measures.

 

 

All of the following are advantages of coupon curve duration EXCEPT it:

A) presumably reflects market expectations.

B) is limited to generic mortgage-backed securities (MBS).

C) is easy to apply.

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It is a disadvantage that it is limited to generic MBS and is not readily applicable to collateralized mortgage obligations (CMO) structures.

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Which of the following is a limitation of cash flow duration?

A) It assumes that the cash flows do not change for a given interest rate shock.

B) It assumes a single prepayment rate over the life of the mortgage backed security.

C) It does not take credit risk into account.

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A major criticism of cash flow duration is that it is based on the unrealistic assumption that a single prepayment rate exists over the life of an MBS for any given change in interest rates. The Monte Carlo simulation does allow for changing prepayment rates, and, therefore, effective duration computed using the Monte Carlo simulation is much better than cash flow duration for MBSs

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All of the following are disadvantages of empirical duration EXCEPT:

A) the volatility of the spreads with reference to Treasuries can distort the price reaction to interest rate changes.

B) it has no theoretical underpinnings or analytical assumptions.

C) time series data on mortgage-backed securities may be difficult to obtain.

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The fact that it has no theoretical underpinnings or analytical assumptions is an advantage of empirical duration, not a disadvantage.

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Which of the following is least likely an advantage of the empirical duration approach?

A) The volatility of the spread to Treasury securities does not distort how the price of mortgage-backed securities (MBS) reacts to yield changes.

B) The only inputs needed are prices and Treasury yields.

C) It does not rely on any theoretical formulas or assumptions.

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The fact that the volatility of the spreads with reference to Treasuries can distort the price reaction to interest rate changes is a criticism of the empirical duration approach.