Lecture 7

Question 1

Convexity

Answer 1

Explains 10% that duration doesn’t.

Embedded options change convexity.

Question 2

Duration

Answer 2

The longer/weirder the bond the more the convexity

Question 3

Strip Bond

Answer 3

A strip bond is a bond where both the principal and regular coupon payments–which have been removed–are sold separately. A strip bond is also known as a zero-coupon bond.

Question 4

Immunization Strategy

Answer 4

Immunization, also known as multi-period immunization, is a strategy that matches the duration of assets and liabilities, minimizing the impact of interest rates on the net worth.

Question 5

Buy and Hold

Answer 5

Your portfolio will go down, your 5 year bond is now a 4 year bond unless you add another bond or move things around

Question 6

Mortgage Pass-Through Securities

Answer 6

Pool mortgage to diversify risk
Investors receive a pro rata share of all CFs
MBS want rates to go down, but not too much

Question 7

Contraction Risk

Answer 7

Average life decreases when rates fall and prepayments increase

• Lower rates lead to more refinancing
• More refinancing shortens average MBS life

Question 8

Extension Risk

Answer 8

Average life increases as rates rise and prepayments fall

• Rates rise causing prepayment to decline
• Average MBS life lengthens