burning0spear

When comparing the number of key rates needed in hedging a mortgage security versus a Treasury security, we generally need to consider:

A) more key rates for the mortgage security because of its bullet payment at maturity.

B) more key rates for the mortgage security because it lacks a bullet payment at maturity.

C) fewer key rates for the mortgage security because it lacks a bullet payment at maturity.

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A Treasury bond’s price is affected most by changes in the yield associated with its maturity, and this is because of the large bullet payment for that type of bond. Because a mortgage security is essentially an annuity, changes of other rates become more important.

burning0spear

In analyzing the risk of mortgage backed securities, we say that:

A) interest rate risk is a component of spread risk.

B) interest rate risk and spread risk are distinct measures.

C) spread risk is a component of interest rate risk.

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Interest rate risk is associated with the risk from movements in Treasury securities. Spread risk is a separate component associated with the credit properties of the security as well as macroeconomic factors.

burning0spear

An increase in the credit spread of a mortgage backed security:

A) increases the security’s value relative to Treasuries.

B) does not change the security’s value relative to Treasuries.

C) decreases the security’s value relative to Treasuries.

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An increase in the spread means the yield of the mortgage backed security has increased relative to Treasuries so the security’s value has decreased relative to Treasuries. This would be an opportunity to buy mortgage backed securities.

burning0spear

Negative convexity is more likely to become more severe if:

A) volatility decreases.

B) volatility increases.

C) the spread increases.

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Negative convexity can be interpreted as the negative effect on price caused by an increase in the value of the embedded, short call option in the mortgage security. An increase in volatility will increase the value of that option and increase the severity of the negative convexity. An increase in the spread and/or Treasury rate will likely increase the yield of the mortgage security, and this will tend to make the security’s convexity more positive.

burning0spear

If a manager of mortgage backed securities is not hedging spread risk, the most likely reason is because hedging spread risk:

A) reduces profitable opportunities.

B) is impossible.

C) increases volatility risk.

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A manager can earn profits by buying mortgage backed securities when the spread widens and selling when the spread narrows.

burning0spear

All of the following are risks associated with mortgage securities EXCEPT:

A) volatility risk.

B) model risk.

C) beta risk.

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Beta is not generally a concept directly associated with mortgage securities. Model risk is important because the current value depends upon patterns of interest rates and prepayment rates. The changing spread can influence the asset’s value. Because of the embedded option, volatility risk is important too.

burning0spear

The effects of recent technological and institutional innovations on the market for mortgage-backed securities has increased:

A) volatility risk.

B) model risk.

C) spread risk.

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The innovations have had a direct effect on the ability of models to predict prepayment rates.

burning0spear

A mortgage security with a face value had a price of 99 at the opening of the trading day. During the day, the yield declined by 80 basis points below its opening yield and then increased 80 basis points above its opening yield. The corresponding prices of the instrument were 99.5 and 98 respectively. From this we can say the security:

A) exhibited excess volatility.

B) exhibited positive convexity.

C) exhibited negative convexity.

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The fact that the price increase from the yield decline was less than the price decrease from the yield increase is indicative of negative convexity caused by a prepayment option.

burning0spear

A mortgage security is most likely to exhibit positive convexity if:

A) the price is below par.

B) the yield curve has a parallel downward shift.

C) the price is above par.

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If the price is below par, the market yield must be higher than the yield on the underlying mortgages, and the prepayment rate will be lower. This means the instrument is more likely to exhibit positive convexity.

burning0spear

A portfolio manager has used a Treasury bond futures contract to hedge a mortgage security, which is trading at par, against a decrease in value from a 50 basis point increase in yield. If the yield were to decrease 50 basis points, the most likely result is:

A) the net value of the position with the hedge will decline.

B) the net value of the position with the hedge will increase.

C) the net value of the position with the hedge will not change.

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The most likely result is that the position with the hedge will decline because of the mortgage security’s negative convexity. As the yield decreases, the prepayment option goes in the money and the value of the security does not go up by as much as the value of the short futures position goes down because the futures position has positive convexity.