Question

Question2:

Answer the following question fixed income securities:

2(i)

The total price volatility of a typical non-callable bond can be found by:

(a) adding the bond’s convexity effect to its modified duration

(b) subtracting the bond’s negative convexity from its positive convexity

(c) adding the bond’s negative convexity to its modified duration

(d) adding the bond’s convexity effect to one half its effective duration

2(ii)

Compared to the underlying MBS, a collateralised mortgage obligation (CMO):

(a) may have more or less prepayment risk

(b) allows an investor to select an exact maturity

(c) has lower duration

(d) has lower credit risk

2(iii)

Securitisation of specific assets by a corporation enables the corporation to:

(a) none of the listed options

(b) get a credit rating on the ABS that will result in a lower cost of borrowing

(c) improve the recovery rate in the event of default

(d) use the assets as collateral for additional borrowing

2(iv)

Which of the following scenarios is most likely to lead to the highest risk of prepayments on a mortgage pool?

(a) A strong economy has caused gross domestic product to rise and unemployment to decline

(b) Mortgage rates are currently at 7.5% and are now declining after varying between 7 and 10% for the last three years

(c) The mortgage pool has an average mortgage rate of 6.25% and an average life remaining of 84 payments. The current mortgage rate is 6.0%

(d) None of the listed options

Answer 1

(2)

i) The total price volatility of a typical non-callable bond can be found by:

(a) adding the bond’s convexity effect to its modified duration

Bond price changes are inversely related to the interest rate changes. Thus. it is said that the bonds have interest rate risk. The interest rate risk of the bonds due to changes in the market interest rates can be measured by calculating the duration of a bond.
Duration of a bond is the weighted average of the present value of the bond's payments (i.e. the present value of the coupon payments & the present value of the principal payment). Duration is also called the average or effective maturity of the bond. Hence, longer the duration greater is the average maturity of the bond , & hence, more sensitive the bond would be to the market interest rate changes. On the other hand. convexity measures the relationship between the a bond's price and its yield as the market interest rate changes.

We can measure the total percentage change in bond's price by adding duration effect to its convexity effect.
Thus, total percentage change in bond's price = duration effect + convexity effect. Since, it is a non-callable bond, we can use either effective or modified duartion in the beforementioned eqaution.

ii) Compared to the underlying MBS, a collateralised mortgage obligation (CMO):

(a) may have more or less prepayment risk.

CMOs or the collateralised mortgage backed securities uses mortgage backed securities as collateral. In a CMO the mortgages are bundled together and sold as an investment, The mortgages are bundled together into different tranches in the order of maturity and risk level. Thus CMOs have several classes of bondholders with varying level of risks and stated maturities. The CMOs redirects cash flows to various bond classes, thus redistributing the prepayment risks of the investors. In other words, with the CMOs, some investors may reduce their prepayment risk exposure while some other investors might increase their prepayment risk exposure. Hence, a collateralised mortgage obligation (CMO) may have more or less prepayment risk.

iii) Securitisation of specific assets by a corporation enables the corporation to:

(b) get a credit rating on the ABS that will result in a lower cost of borrowing.

Securitization is the process of transfer of ownership of assets from its original owners to a special legal entity. The special legal entity then sells securities backed by these assets to investors in the market & the cash flows generated from these assets are then used to pay interest & repay the principal owed to the investors of these securities. The assets used in the securitization are like residential mortgages, commercial mortgages. auto loans, bank loans, credit card debt obligations etc. Thus the securities generated from the Securitization process are called Asset backed securities (ABS), where the pool of assets are called the collateral.

The securitization process have several benefits. It gives investors access to liquid investments and good payment streams. Also through securitization, the banks are enabled to give more loans as compared to only if they had used their in-house loan giving capacity. Thus, the securitization process also lowers the cost of borrowing for the entities who are raising external funds.

In securitization, the assets are divided into several bond classes or tranches. These bond classes / tranches are then assigned different credit ratings by the concerned credit rating agencies depending upon the crdit risks of the collateral of the different tranches. The securitization of a company's assets may include some bond classes that have better credit ratings as compared to the company itself or its corporate bonds. Thus, the company may lower its cost of borrowing when raising external funds through the process of securitization than issuing corporate bonds.

iv) The following scenario which is most likely to lead to the highest risk of prepayments on a mortgage pool :-

(a) A strong economy has caused gross domestic product to rise and unemployment to decline.

Prepayment risk on a fixed income security (for e.g. callable bonds & mortgage backed securities) occurs when the debtors repay the principal early so that they don't have to make the interest payments on that part of the principal. As a result the investors in that fixed income security will not receive the interest in that portion of the principal returned early by the borrower.

As the economy grows, people moves on to better and higher paying jobs and also the unemploymet rate decreases. Thus the personal income of the people rises. This leads to early mortgage payoffs and prepayments.
The other given scenarios do not carry much risks of prepayments. In the option (c) the incentive to refinance is not so great only for 0.25% spread and for a relatively shorter time period left for the mortagage. Again in the option (b), where the mortgage rates are fluctuating up and down can lead to refinancing burnout. Refinancing burnout is the drop in the prepayments after the mortgage rates drop, rise and fall again. This is because the borrowers who wanted to take advantage of the falling rates have already done so in the previous rate declining periods.