Question

1) What is the unique attribute of the cash flow of a MBS pool when comparing it to a conventional bond such as a Treasury or Corporate bond?

2) Investment bankers will pool ________ to create MBS.

3)Briefly discuss what is meant by extension risk in MBS analysis.

4) Briefly discuss what is meant by contraction risk in MBS analysis.

5)The one unknown (risk) that is unique to MBS pools is ___________________.

6) When considering two Fannie Mae pools, the MBS pool with a lower Coupon would imply a faster or slower prepayment rate?

Answer 1

1) In case of a conventional bond discount factors could be calculated at different specific points over the maturity term.

However in case of Mortgage Backed Securities (MBS) Pool the duration reflects the simultaneous relationship between yield curve and price thereby deducing that cash flows change with their interest rates.

2) Investment bankers will pool MORTGAGE LOANS to create MBS.

3) Due to market conditions the borrower of loans might extend the number of days of their average payment cycle i.e. the borrowers defers their loan prepayments and this risk is prevalent due to the market condition unsuitability expected by the borrowers. Such form of Risk is known as extension risk in MBS Analysis.

4) In a contraction risk the investor is at risk due to the borrowers paying off all the amount of loan due to interest decline and hence life of the loan instument decreases. Therefore quick prepayment of the loan by the borrower due to the falling of interest rates becomes a loss for the investment bankers. This risk prevalent in MBS Analysis is Contraction Risk.

5) One unknown risk that is unique to MBS Pools is CONVEXITY EVENT RISK.

6) The MBS pool with a lower coupon will imply a faster prepayment rate when considering two Fannie Mae pools.