Interest Rate effect I.O. & P.O.

@ykilstein apologies – corrected!

@sophie 🙂 just wanna be extra sure, wouldn’t want @ykilstein to get the wrong concept to the exam hall 😛

Hi @ykilstein, that’s so weird, @adossa3 just posted a similar question. Here’s my answer to #1:

For principle-only and interest-only MBS, here’s the conceptual reasoning:

• Declining interest rates increase PO repayment speed, lowering the discount rate and increasing the PO price. Hence +ve duration.
• Declining interest rates mean that repayments speed up, so there’s less interest paid (lower principal, plus lower interest rates), so IO value decreases. Hence -ve duration.

So yes, your statement on #1 is correct.

1. PO – yes as it’s like a bond. Negatively correlated with interest rates.
IO – when I/R increases -> lower prepayment -> with more principal in the pool and higher I/R -> price goes up.
though

2. volatility affects pretty much all financial instruments, including IO and PO.

as far as i know, volatility affects bonds with options (puts and calls) as it creates uncertainties on who’s gonna gain from it.

As for option free bonds, since the calculation is greatly relying on the I/R so theoretically it shouldn’t, maybe someone else can confirm this?

@vincentt – have faith in yourself 🙂 What you said sounds perfect Jr Portfolio Manager!