FRM Question - Yield Curve and Negative Convexity

[dennis_cmpe]

Can you clarify the explanation for this question? I don't understand how it answers the question.

Here was my approach to this problem (please correct if I'm way off track):

1) MBS securities -> negative convexity
2) Steepening yield curve -> higher yields -> lower prices

I thought the answer would be either B or D since prices will drop for the MBS security, and therefore negative convexity won't really matter.

Even if yields did get to the point where negative convexity kicked in, the price of the MBS would still be much higher than when yields rise?

I chose D.

22) At present market levels, which yield curve shift is most dangerous to holders of mortgage-backed securities (MBS) 6.5% notes?

a. Parallel yield curve shift in a market rally
b. Steepening yield curve shift in a market rally
c. Flattening yield curve shift in a market rally
d. Steepening yield curve shift in a market sell-off

ANSWER: C

As the market intensifies, negative convexity increases much faster due to rapidly shortening duration.
​

 

[David Harper CFA FRM]

Hi Dennis,

(Is this from GARP??)
I've stared at this for 10 minutes, I don't get this question either. Here is my mental process, since i do not have a secret decoder ring for this question:

the phrase "flattening yield curve shift" throws me a little. I'll assume that's just a FLATTENING (a.ka., which by definition is a non parallel shift). But okay, i see there is rally & sell-off.

So, a FLATTENING RALLY = downward shift (the rally) combined with flattening (slope decreases)

My first instinct is: the SELL OFF (answer D) because, well, that's the one where prices go down! The others are RALLYs. So, I pick D also. What am i missing, isn't a rally better than a sell-off ??

Hi certainly agree with your two points:

1) MBS securities -> negative convexity
2) Steepening yield curve -> higher yields -> lower prices

I would only add that, for the negative convexity portion of the MBS, lower yield associates with lower duration. So, I get this part: lower yield creates "shortening duration." So I *think* what the answer is getting at is the fact that as yield decrease (the RALLY), the price appreciation is tempered by lower duration...but then frankly i lose the thread in seeing how this is worse for a flattening...

David