CFA CFA Level 2 Interest Rate effect I.O. & P.O.

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

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• 0

1. To confirm, by looking at CFAI’s chart, (FI R55 p. 435-437) a rise in interest rates would decrease the price of a P.O. and increase the price of an I.O. Am I right?

2. Does volatility effect passthroughs?

• 4

PS CFAI’s language tends to be obtuse.

• Zee Tan
Keymaster
• CFA Charterholder
3

@ykilstein apologies – corrected!

• 2

@zee Thanks! I may have to re-read your post to get the logic but at least I have the facts memorized.

FYI “principal”-only.

• vincentt
Participant
• CFA Level 3
2

@sophie ðŸ™‚ just wanna be extra sure, wouldn’t want @ykilstein to get the wrong concept to the exam hall ðŸ˜›

• Zee Tan
Keymaster
• CFA Charterholder
1

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

@zee dumb Q: how do I edit my posts after I post them?

@vincentt
another dumb Q: If volatility goes up, doesn’t the volatility associated with the (option-free) bond go up? i.e. If vol. goes up, does the bond price go ____?

• 1

@vincentt That sounds abt right. I may be thinking too deeply abt this ðŸ™‚

• vincentt
Participant
• CFA Level 3
0

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.

• vincentt
Participant
• CFA Level 3
0

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?

• 0

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