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

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

  • This topic has 10 replies, 4 voices, and was last updated Apr-17 by vincentt.
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  • ykilstein
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    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?

    ykilstein
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    PS CFAI’s language tends to be obtuse.

    Zee Tan
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    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.

    vincentt
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    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.

    ykilstein
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    @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.

    Zee Tan
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    @ykilstein apologies – corrected!

    ykilstein
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    @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 ____?

    vincentt
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    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?

    ykilstein
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    @vincentt That sounds abt right. I may be thinking too deeply abt this 🙂

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

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

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