MBS Vs ZeroCouponBond : Yield curve twist impact?

Discussion in 'GARP Part 2 (P2) Practice Exam Questions' started by rajeshtr, Dec 25, 2016.

  1. rajeshtr

    rajeshtr Member

    Hi David, What is the impact of Yield curve twist : My initial reaction after seeing this question is that ZeroCouponBonds accumulate the payments towards the end and must be the most sensitive.. compared to the MBS which sends Monthly/frequent payments..

    Kindly clarify?

    But apparently the answer seems to be C) when the volatility increases and the shorted option cost increases - the negative convexity is decreasing the price of the MBS bond (even thought this option didn't compare the price against the regular bond which would have increased in price when Yield decreased..)

    MBS-ZCB Price vs Yield curve Twists.png
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  2. David Harper CFA FRM

    David Harper CFA FRM David Harper CFA FRM (test) Staff Member

    Hi @rajeshtr

    A yield curve twist refers to a type of non-parallel shift in the yield curve which is either a flattening or steepening of the curve (see Tuckman below; although there can be other types of non-parallel shifts). So I think the intention of choice (A) is based on the fact that a zero-coupon bond only discounts the final par cashflow, but an MBS discounts cash flows along the entire term structure. For example, consider a yield curve that starts at a short rate of 0.5% and ends with a long rate (say, 20 years) at 5.0%. Imagine a flattening (ie., twist) such that the long rate remains at 5.0% but the short rate jumps to 3.0%. The 20-year zero-coupon bond is presumably, generally unaffected (same spot rate) but the MBS is greatly affected by several spot rate changes.

    With respect to (C), for me the easiest approach here (which does not require a deep dive into OAS) is to rely on our key mortgage/MBS analogy: a mortgage/MBS is effectively a bond with a call (prepayment) option. Prepayment is exercise of an option held by the issuer (borrower). Consequently, we can use: [value of callable bond] = [value of option-free bond] - [call option], where an increase in yield volatility --> increase in the call option --> decrease in value of callable bond. So (C) is a pretty clean answer, IMO. I hope that helps!

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    DUVALGUI New Member

    b/ when the yield is higher than the coupon rate of the MBS, we can assume that there is no prepayment so the MBS should be like a corporate bonds c/ when volatility increases the value of the Embedded option increases ie the MBS
    value increases d/ it is the defintion of an MBS when interest rates decreases borrower redeemed their loans dur to the fact that they get a free option .... so a at the end remains A/ ... for me on a ladder the zero coupon is the bond the max sensitive to interest rate move.... but I would say A by elimination as I don't see the rationale with A

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