Question regarding prepayment risk

CFA Level I Fixed Income
#1

Hi all

I have a question regarding prepayment risk.

Why does rapid prepayment decreases cash flows from IO (Interest only) strips??

Thanks alot!

#2

Suppose that Bob takes out a 30-year mortgage on his home. The person who buys the IO strip on Bob’s mortgage expects to get interest payments for 30 years.

But Bob – the bum! – gets a new job five years down the road and moves to New Jersey, selling his house in Arizona. Pffft! there goes 25 years of interest payments, and the sucker who bought the IO is out of luck: the cash flows are gone. Zip! Zero! Nada!

(Note that the savant who bought the PO just got all of his money back: Bob paid off the balance on his mortgage.)

(Moral of the story: never – _ never! _ – trust someone named Bob.)

#3

this is a question one has to ask? wow.

#4

haha that is pretty rude, I would rather ask silly questions now than fail in the exam. This forum is for learning, no?

#5

Dude, a charterholder bashing a L1 candidate. What next Itera, pushing the crippled boy down?

#6

When we prepay the full or partial amount of the Principal, we need to pay interest on the rest of the amount which is now less. So, interest amount itself goes down bringing down the IO strips…