Two issues came up in relation to this question and I’ve been virtually banging my head against the wall enough.
In part A, they do not add the risk of 10 year treasuries over the 1 yr treasuries to the 10 yr MBS. The spread for the 10 yr MBS is listed as being over the 10 year teasuries; it has the footnote “This spread implicitly includes a maturity premium in relation to the 1-year T-note as well as compensation for prepayment risk.”
So is that footnote confusing to anyone else? The spread is listed as over the 10 yr treasury but the footnote says it’s in relation to the 1 yr T-note.
In part B, it’s the same issue as above - teh 10 year MBS spread fouls up the calculation.
Can anyone explain to me what I’m missing here - the footnote contradicting the table has me rather confused.
I was confused about this too… see below thread…
I still don’t have answer yet… check my last post in that thread.
http://www.analystforum.com/forums/cfa-forums/cfa-level-iii-forum/91340329
Though it was made to purposely confuse us, the given answer made some sense
“This spread implicitly includes a maturity premium in relation to the 1-year T-note as well as compensation for prepayment risk.” This means that the spread of 95bps of MBS over 10-year T-bonds already included the 100 bps spread over the 1-year T-note. In order word:
1% + MBS prepayment risk spread = 0.95% = 10-year MBS prepayemnt risk spread (over 10-year Treasury), which mean the prepayment protection somehow reduced the spread.
Therefore the 10-year MBS is 1 year US T-note + 0.95%
I hope this type of question won’t be on the exam because it is not very straightforward.