Is MBS non-callable bond or callable bond?
This is another interesting question ! MBS is callable bond. But MBS’s duration is shorter than callable bond, all else being equal due to amotized cash flows (each cash flow includes principal repayment) of MBS. If I am wrong, please correct me.
P155 of Vol 4, Q27, I am trying to understand why contingent claim risk is still a risk for non-callable bond portfolio…any thoughts?
There were discussions on this forum but no conclusion. To me, contingent claim risk shall not be a risk for non-callable bond portfolio.
Unless MBS can be included into non-callable bond camp. BTW, Does MBS always have embedded option??
lzhao Wrote: ------------------------------------------------------- > Unless MBS can be included into non-callable bond > camp. > > BTW, Does MBS always have embedded option?? yes, the prepayment option. It is not always valuable to the holder though.
Leo_land, Then, is MBS callabled or non-callable bond? How does MBS differ from traditional callable bond?
Mortgaged-backed securities are not a bonds at all but they GENERALLY behave like a callable bond when rates are low. 1. A callable bond exhibits price compression when rates are low (or rates are below coupon) because it is likely the corporation will exercise the option. That is, call the bonds and refinance at lower rates. This is negative convexity. 2. A MBS exhibits price compression when rates are low because it is likely that mortgage holders will refinance at lower rates which will entail a prepayment of current mortgage. This is negative convexity. So to CAREFULLY answer your question, MBS are not bonds but exhibit the same negative convexity as callable bonds in a low interest rate environment where the option becomes more valuable.
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AMC Wrote: ------------------------------------------------------- > There were discussions on this forum but no > conclusion. > To me, contingent claim risk shall not be a risk > for non-callable bond portfolio. Agree. Q27 is just not properly constructed.
My question is: Does contingent claim risk ONLY relate to bonds with options?
lzhao Wrote: ------------------------------------------------------- > My question is: > Does contingent claim risk ONLY relate to bonds > with options? I think so.
Leo_land Wrote: ------------------------------------------------------- > Mortgaged-backed securities are not a bonds at all > but they GENERALLY behave like a callable bond > when rates are low. > > 1. A callable bond exhibits price compression > when rates are low (or rates are below coupon) > because it is likely the corporation will exercise > the option. That is, call the bonds and refinance > at lower rates. This is negative convexity. > 2. A MBS exhibits price compression when rates > are low because it is likely that mortgage holders > will refinance at lower rates which will entail a > prepayment of current mortgage. This is negative > convexity. > > So to CAREFULLY answer your question, MBS are not > bonds but exhibit the same negative convexity as > callable bonds in a low interest rate environment > where the option becomes more valuable. Just to clarify on this point. Its not the corporation that refinances, its the people who have taken out the mortgages. They have the call option.
chedges Wrote: ------------------------------------------------------- > Leo_land Wrote: > -------------------------------------------------- > ----- > > Mortgaged-backed securities are not a bonds at > all > > but they GENERALLY behave like a callable bond > > when rates are low. > > > > 1. A callable bond exhibits price compression > > when rates are low (or rates are below coupon) > > because it is likely the corporation will > exercise > > the option. That is, call the bonds and > refinance > > at lower rates. This is negative convexity. > > 2. A MBS exhibits price compression when rates > > are low because it is likely that mortgage > holders > > will refinance at lower rates which will entail > a > > prepayment of current mortgage. This is > negative > > convexity. > > > > So to CAREFULLY answer your question, MBS are > not > > bonds but exhibit the same negative convexity > as > > callable bonds in a low interest rate > environment > > where the option becomes more valuable. > > > Just to clarify on this point. Its not the > corporation that refinances, its the people who > have taken out the mortgages. They have the call > option. In “1” above, he’s referencing callable corporate bonds and comparing them to MBS securities to demonstrate/explain negative convexity, so in his example, it is the “corporation” that refinances. If you wanna get real technical about it, there’s generally penalties on corporations (and home buyers as well) for exercising their prepayment option (corporations would have to pay off current holders at like 103, home buyers would have to pay points, etc), so there’s a small band where rates are below the bond coupon but above the threshold at which is makes sense for them to refinance, and the bond behaves like an option-free bond. And that’s all for tonight.
Izhao, I found this on page 38 of Vol. 5. Types of risks faced by FI liabilities: 1) Interest rate risks - my understanding is that this is for both callable and non-callable bonds 2) Contigent claims risk - According to the paragraph, I feel CCR is only for callable bonds. So you might right on this. 3) Cap risk - This could for both callable and non-callable bonds (pls. confirm this though) Hope that helps.
My understanding is that Cap risk applies to bonds with floating payments. If the interest rates go up the bond can have embedded cap that doesn’t allow the payment to increase above certain level. So the holder of the bond will not receive CF above certain level => Cap Risk.
Thanks ptica. Thats what I felt too, cap risk for floating payments. Wouldn’t make sense on fixed anyway.
nailed it
Just want to thank everyone , I found this helpful in 2023.
You contigent claim risk in deriavtives - options, credit default swaps.
Contigent claim risk will exist when one party has the choice to do something or not, or where a formula makes it happen.
Coco (Contigent convertible) bonds - bonds that convert to equity in a particular set of circumstances.
So yes a contingent risk exists when a bond has an option but don’t restrict yourself to just thinking just of the traditional callable, putable, convertible and (MBS). Also some like writedown CoCo will convert automatcally - contigent upon an event.
With MBS we have prepyament risk which comes from the fact that homeowners have flexible repayment schedules which can be though of as the homeowner having a series of calls with zero strike.
The are different as with a corporate issuer callable bond you would expect that the call is only made when it makes financial sense but with a mortgages individual are repay early for many reasons - death, divorce, moving home - not based on interest rates. Although when we aggregate from indvidual homeowners to the whole MBS then interest rates are the most influential factor.
So MBS have risl similat to a callable bond, there is contigent claim risk, the nature of it is similar to callable bonds - especially as low interest rates and the dominant issue - but the risks are different enough that we should really think of it as pre-payment risk.
The syllabus refers to contigent provision when refering to bonds with options etc but not when referring to MBS.