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Answer: The accurate duration will be lower than 5.3 years
**Correct answer: A** If Barry varies the PSA assumption consistently with the interest-rate scenario, then the embedded prepayment option is modeled more realistically. When yields fall, prepayments usually increase, which reduces the MBS price more than Barry’s original calculation assumed. That makes the security **less sensitive to interest-rate changes**, so the **effective duration is lower** than 5.3 years. In addition, both duration and convexity tend to decrease when PSA is adjusted appropriately, and convexity can become more negative. Therefore, the accurate duration is **lower than 5.3 years**.
Author: Manit Arora
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Question-105.3. Barry the analyst calculated the effective duration of a pass-through MBS as 5.3 years. His effective duration is based on re-pricing the MBS with a yield shock of 50 basis points; i.e., current yield plus and minus 50 bps. However, Barry’s manager observes that Barry did not vary the prepayment (PSA) assumption when re-pricing under either the higher/lower yield scenarios. His manager argues that Barry should vary the PSA assumption as he varies the interest rate input. If Barry varies the PSA assumption as instructed by his manager, which of the following is TRUE?
A
The accurate duration will be lower than 5.3 years
B
The accurate duration will be higher than 5.3 years
C
It does not matter, neither duration nor convexity will be impacted
D
Duration is approximately unchanged at 5.3 years but convexity will increase
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