I think this sample practice misconstrues negative convexity, but maybe somebody can do better? - David

[source: 2009 sample exam II]  36. Your firm’s fixed‐income portfolio has interest‐only CMOs (IO), callable corporate bonds, inverse floaters, noncallable corporate bonds. Your boss wants to know which of the following securities can lose value as yields decline.

a.  callable corporate only
b.  inverse floater only
c.  IO and callable corporate bond
d.  IO and noncallable corporate bond

[my adds]

36b. What is unique about the duration of an interest only (IO) strip?
36c. What is unique about the duration of an inverse floater?
36d. How does the price of the callable corporate bond compare to the price of a noncallable corporate bond, for both low and high yields (assume otherwise identical features)?
36e. How and where (in the yield curve) does the call option induce negative convexity?
36f. Does negative convexity imply negative duration?

Answer here in forum or here in wiki.

Comments

1. concepts 30 Aug 2009

   Callable bond [practice, market]
   Hi David,
   From this your graph above, let us replace non prepayable mortgage with non callable corporate bond, and pass through with wit callable corporate bond: (F. Fobozzi)  has a similar graph in Fixed income analysis for CFA program (level 2)

   As the yield declines, the option embedded in the callable corporate bond becomes more and more in- the- money (ITM). As it becomes more and more obvious that the bond will be called, its price appreciation will be capped at a certain point after which it will start to exhibit negative convexity (will not appreciate as relatively as non callable bond)

   Given this, it will be to see   from the options given by GARP on this question we can see that   it has to be (a) (CMO IO since we all know that when interest rate (yield) decline, homeowners will refinance/ prepay etc,( with the effect of reducing the interest cost or the principal outstanding)     
   ( b) callable corporate bond. 

   Callable bond in the corporate world is equivalent to the prepayable pass through (CMO, IO)  in the mortgage world because each has a an embedded option that the corporation /issuer/ homeowner will take advantage of

   Thanks,

   Concepts

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