The question says MBS prices are going down, so int should be increasing. Then is it int risk or contingent claim risk. Bcos contingent claim risk is associated with drop of int. What do you think? (giveb answer is contingent claim risk).
MBS goes down when the value of its option is going up. Option value increases when interest rate volatility is high or interest rate is going down. Therefore, interest is simplied to be going down.
At negative convex, price stop going up as int decrease. But price doesn’t come down, isn’t it?
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you are correct, if MBS prices are going down then interest rates are increasing. if interest rates fall then MBS prices will increase, just not as fast as noncallables.
From the information on the question it sounds like it is poorly worded. If MBS values are going down, theoretically you could be at any point on the curve, the only thind that has to happen is interest rates increase. if you are on the lower end of the curve, the MBS value would go down slowly, and if you are in the middle of the curve it would go down faster.
The lower end of the curve is where contingent claim risk is more present for MBS’s and Int rate risk is more present in the middle of the curve. so the answer really depends on where in the curve you are.
think if rates rise MBS prepayment speeds are affected ( i.e. they reduce ) . So there is contingent risk in rising rates too. If we talk about MBS we’re not talking about ordinary bonds.
Most MBS investors would hedge interest rate exposure and only try and earn the spread ( the OAS).
The OAS model uses assumptions of prepayment speed and will be hurt by either slow or fast prepayments
BTW : I would have picked interest rate risk too.
If rates rise , the probability of prepayment goes down. So risk of prepayment decreases.
I think the guideline answer is trying to say that since the rates have been rising thus MBS dropping, it is likely for interest rates to revert to the mean and start dropping, therefore, there is the worrying of the contingent claim. But I also got this one wrong, the Q is ambiougus.
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