If there is a decrease in interest rates, then what will be the effect on interest only stripped MBS and principal only stripped MBS?
A. Both will increase
B. Both will decrease
C. One will increase and other will decrease
Why is answer C correct? should it not be A?
Another stupid question written by someone who isn’t as clever as they think.
The correct answer is: they might both increase, or it might be that the PO increases and the IO decreases.
It depends on the level of interest rates.
For very low interest rates, IOs have negative (effective) duration: if interest rates rise, their prices go up, and if interest rates fall their prices go down. For high interest rates, IOs have positive (effective) duration: if interest rates rise, their prices go down, and if interest rates fall, their prices rise.
POs have positive (effective) duration everywhere.
thank you sir, and is there any chance that we’ll see these type of ambiguous questions on the exam?
None.
Alrighty.