Reading 21- eoc #18 solution says
[question removed by moderator]
Can anyone make it clear for me?
Negative convexity arises from call options or prepayment options; for MBS passthroughs, it’s prepayments.
Homeowners refinance mortgages when the new interest rate is sufficiently lower than their existing interest rate. If their existing rate is high – leading to high-coupon MBSs – they’re more likely to refinance, and will do so at higher market rates; if their existing rate is low – leading to low-coupon MBSs – they’re less likely to refinance, and will do so only at lower market rates.
For example, if your existing mortgage rate is 6%, you may refinance if rates will drop to 5%, and are more likely to to so if they drop to 4%, 3%, or 2%. However, if your existing mortgage rate is 4%, you won’t refinance when rates are at 5%, or 4%; you may refinance at 3%, and are more likely to do so if they drop to 2%.