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Written by Bill Berliner
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Thursday, 16 July 2009 07:19 |
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Excerpted with permission of the publisher from Mortgage-Backed Securities: Product, Structuring and Analytical Techniques, by Frank Fabozzi, Anand Bhattacharya, and William Berliner Copyright 2007 by John Wiley & Sons, Inc. All rights reserved. The book is available at all bookstores and online booksellers, including www.Wiley.com. As discussed, duration is a first approximation of the expected price change for a small change in yield. As the yield changes grow large, the estimation error grows larger; this is particularly true for MBS, where the prepayment option introduces significant curvature into the bond’s price/ yield function. Convexity is a second approximation of the expected price change. It represents how much the bond’s duration is expected to change, given changes in yields. An illustration of convexity is shown in Exhibit 11.2. The exhibit highlights the change in the slope of the tangent lines at different points in the bond’s price/yield relationship. |
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Last Updated on Thursday, 16 July 2009 08:03 |
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Excerpted with permission of the publisher from Mortgage-Backed Securities: Product, Structuring and Analytical Techniques, by Frank Fabozzi, Anand Bhattacharya, and William Berliner Copyright 2007 by John Wiley & Sons, Inc. All rights reserved. The book is available at all bookstores and online booksellers, including www.Wiley.com. The PAC/Support structure is designed to create mortgage bonds that have reduced exposure to prepayment risk and cash flow uncertainty, and creates securities targeted to appeal to buyers of bullet structures such as corporate bonds. The structuring process involves dividing the available cash flows within a deal into two or more groups, and assigning one group priority in receiving scheduled amounts of monthly principal payments from the collateral. The result is that the prioritized group (and bonds tranched from it) has average lives, durations, and cash flow windows that are constant within a predesignated range of prepayment speeds. The bonds that are lower in priority, however, have increased cash flow volatility, and typically trade to higher yields to entice investors. |
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