Dear David,
I’ve had some confusion, misunderstanding and doubts when doing 09 Level I Annotated Boot Camp. Appreciate your kind help on this!
In sub question 8e under question 8 (see below), the P&L impacts are ranked for a MBS, with the duration approach having the highest impact and full re-pricing having the lowest impact. I’m just wondering if this is the case because I think what should always hold for MBS is that the duration approach will gives the highest price in the valuation and full re-pricing gives the lowest price in the valuation. What is not necessarily the case is the impact or the change in MBS valuation, considering that the impact refers to the absolute value of change in prices. For example, under duration approach, bond prices increases versus the old price; under full pricing, the prices decreases versus the old price, so the first price is higher than the latter but the absolute deviation from the initial price is yet to determine and compare.
8. Consider the following four methods for estimating the P&L of a bullet bond: Full-repricing, Duration (PV01),and Duration plus convexity. Third-order Taylor series approximation.
8a. [sample exam] Ranking the estimated P&L impact of a large negative yield shock from the lowest P&L impact to the highest P&L impact, what is the ranking of the methods to estimate the P&L impact?
8e. Replace the bullet bond with a mortgage-backed security (e.g., a pass through on a pool of 30-year mortgages), assume the initial yield is low, and then recast the rankings based on MBS.
Your Answer: 8e. Replace the bullet bond with a mortgage-backed security (e.g., a pass through on a pool of 30-year mortgages), assume the initial yield is low, and then recast the rankings (i.e., the ranking of estimated P&L impact based on large negative yield shock) based on MBS. The MBS will exhibit negative convexity at low yield (why?). Therefore the situation is reversed: Full re-pricing will have the lowest impact and duration (being the least accurate) will have the highest impact.
Thank you for your enlightenment and correction!
Cheers
Liming
16/11/09
I’ve had some confusion, misunderstanding and doubts when doing 09 Level I Annotated Boot Camp. Appreciate your kind help on this!
In sub question 8e under question 8 (see below), the P&L impacts are ranked for a MBS, with the duration approach having the highest impact and full re-pricing having the lowest impact. I’m just wondering if this is the case because I think what should always hold for MBS is that the duration approach will gives the highest price in the valuation and full re-pricing gives the lowest price in the valuation. What is not necessarily the case is the impact or the change in MBS valuation, considering that the impact refers to the absolute value of change in prices. For example, under duration approach, bond prices increases versus the old price; under full pricing, the prices decreases versus the old price, so the first price is higher than the latter but the absolute deviation from the initial price is yet to determine and compare.
8. Consider the following four methods for estimating the P&L of a bullet bond: Full-repricing, Duration (PV01),and Duration plus convexity. Third-order Taylor series approximation.
8a. [sample exam] Ranking the estimated P&L impact of a large negative yield shock from the lowest P&L impact to the highest P&L impact, what is the ranking of the methods to estimate the P&L impact?
8e. Replace the bullet bond with a mortgage-backed security (e.g., a pass through on a pool of 30-year mortgages), assume the initial yield is low, and then recast the rankings based on MBS.
Your Answer: 8e. Replace the bullet bond with a mortgage-backed security (e.g., a pass through on a pool of 30-year mortgages), assume the initial yield is low, and then recast the rankings (i.e., the ranking of estimated P&L impact based on large negative yield shock) based on MBS. The MBS will exhibit negative convexity at low yield (why?). Therefore the situation is reversed: Full re-pricing will have the lowest impact and duration (being the least accurate) will have the highest impact.
Thank you for your enlightenment and correction!
Cheers
Liming
16/11/09
