Fin 4319-Record C2 Flashcards
what is a cmo?
collateralized mortgage obligations -a mortgage backed bond issued in multiple classes or tranches
what is a tranche?
a bond holder class associated with a CMO
a sequential pay cmo
any prepayments go to class 1 first until full principal been repaid, and then principle payments go to class 2 until they are paid off, it goes to 3, and 4. the duration is more certain.
who loan origination experts/brokers?
they sell these mortgages to those who form pools, and the sell to co.
what is the duration of class 1, 2, 3, 4?
short term, int term, long term, very long term.
all classes have negative convexity
who invests in short term?
banks, savings accounts and CD’s
who invests in intermediate term tranche?
property casualty co.,
long term tranche?
pensions funds, life insurance
very long term tranche?
endowment funds, life insurance
when did CMO’s start?
1960’s by freddie mac
how create 3 tranches shorter term than
z class accrual bond
PAC and Support Bond
Planned Amortization Class - fixed average life over wide range of prepayment speeds, borrow cash-flow from the support bond or add cash flow to support bond in order to create planned amortisation. it has a fixed average life, it would have positive convexity
which trades higher PAC or support bond?
support bond, they buy it for higher yield but less predictable life and duration. negative convexity. for investors don’t need to immunise
For PAC, what is the yield? life or duration? convexity?
Lower yield, stable duration, positive convexity
For Support, what is the yield? life or duration?
Higher yield, less predictable duration, negative convexity
What is PSA?
public securities association (PSA) is a prepayment speed benchmark expressed as a monthly series of annual prepayment rates.
What is CPR?
annual prepayment rate
how do you compute average life of mortgage pool at speeds?
average life of 100 to be 11-12 years.
what is average life of MBS?
The average life of a mortgaged backed security is the average time to receipt of principal payments (scheduled principal payments and projected prepayments), weighted by the amount of principal expected.
For CMO what happens when interest rates fall and prepayment speed is high?
the average life could get shorter, 4-5 yrs,
For CMO what happens when interest rates rise?
no body refinance so prepayment speed slows, average life or duration ~15-18 years, that’s why you get negative convexity
how does the Support Bond help the PAC?
the support bond takes the prepayment risk so the PAC can be more stable
agency striped mortgage backed securities
it is a derivative mortgage security created by Fannie Mae.
are derivatives bad?
no derivatives are tools to help manage risk, it’s the person using them are bad
what is PO?
principle only - assuming 100 PSA, life is 11 years - very sensitive to interest rate change, when rates go down, cash flow goes up and prepayment faster, when rates go up, cash flow goes down, prepayment slows down. asset duration is long, when prepayment is faster, you bet
for po, what if prepayment speed is faster than expected?
make it worth more
for po, what if you think prepayment speed will be faster than expected?
you will betting interest rates will fall, prepayment speed go faster, PO is great for speculator
What is IO?
interest only - don’t know interest payments going to be - if people pay early, not much interest
what happens to IO with interest rates?
int rates fall: IO decrease value, prepayment faster, and investor receives less interest
int rates rise: IO increase value, prepayment slows, and you receive more interest payments
what is the duration of IO?
it has a negative duration
why you buy IO?
you bet interest rise
how does IO move compared to most fixed income securities?
security moves opposite of most fixed income securities
how do you hedge (or protect against) contraction risk?
buy PO because it has positive duration to lengthen duration of portfolio
how do you hedge (or protect against) extension risk?
buy IO because it has negative duration to shorten duration of portfolio
what is the market for the actual commodity?
spot market or cash market
