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Answer: As the PSA increases (e.g., 100% to 300%), the value of the interest-only (IO) bond will increase
### Correct answer: **A. As the PSA increases, the value of the IO bond will increase** An **IO strip** receives only interest payments. When prepayments speed up: - The mortgage principal is returned earlier, - The outstanding balance declines faster, - Future interest payments are reduced, - Therefore, the **value of the IO decreases**. So **A is false**. Why the others are true: - **B is true**: A **PO strip** benefits from faster principal return, so its value generally **increases** as PSA increases. - **C is true**: When the IO and PO strips are combined, their value-weighted duration relationship is consistent with the duration of the original pass-through security. - **D is true**: Because IOs lose value when rates fall and prepayments rise, their duration is often **negative**, sometimes strongly so. Hence, the exception is **A**.
Author: Manit Arora
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Question 107.3. A pass-through mortgage-backed security (MBS) has an effective duration of 12.0 years. The security is structured into two bonds: an interest-only (IO) strip and a principal (PO) strip. Each of the following is true EXCEPT:
A
As the PSA increases (e.g., 100% to 300%), the value of the interest-only (IO) bond will increase
B
As the PSA increases (e.g., 100% to 300%), the value of the principal-only (PO) bond will increase
C
The weighted average sum of the durations of the IO and PO strips must equal the 12.0 duration of the original pass through.
D
The duration of the IO strip is likely to be negative, even substantially negative
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