Mortgage Prepayment and Default Risk Modeling

Play an AI-generated podcast conversation about this lesson

What is the Macaulay duration of the barbell portfolio?

Ten years
Eight years
Six years (correct)
Four years

What happens to the short-term yields in the steepening twist scenario?

They remain unchanged
They go down (correct)
They go up
They increase and then decrease

What is the effect of the steepening twist on the value of the barbell portfolio?

It becomes volatile
It remains unchanged
It increases
It decreases (correct)

What is the maturity of the zero-coupon bond that provides perfect immunization?

Six years (A) Signup and view all the answers

What happens to the six-year yields in the scenario depicted in Exhibit 11?

They go down (D) Signup and view all the answers

What is the composition of the immunizing portfolio with a 'barbell' structure?

Half short-term bonds and half long-term bonds (B) Signup and view all the answers

Why would a homeowner elect to prepay their mortgage?

To take advantage of refinancing opportunities if interest rates decrease (A) Signup and view all the answers

What type of asset is a fixed-rate government bond?

Type I asset (C) Signup and view all the answers

What is the primary source of uncertainty in demand and time deposits from a savings bank's perspective?

The timing of the deposit redemption (C) Signup and view all the answers

What type of liability is a contingent convertible bond?

Type IV liability (B) Signup and view all the answers

What is the primary goal of liability-driven investing in most circumstances?

To manage the interest rate risk of multiple liabilities (B) Signup and view all the answers

What is the effect of a decline in home prices on the default risk of mortgages?

It increases the default risk, especially for mortgages with higher loan-to-value ratios (C) Signup and view all the answers

What is the primary requirement for the bond portfolio's initial market value to achieve interest rate immunization?

Its present value should match or exceed the present value of the zero-coupon bond (C) Signup and view all the answers

What is the relationship between the Macaulay duration of the zero-coupon bond and the investment horizon?

The Macaulay duration is always equal to the investment horizon (C) Signup and view all the answers

What is the condition required for immunization to be achieved?

Any change in the cash flow yield on the bond portfolio is equal to the change in the yield to maturity on the zero-coupon bond (D) Signup and view all the answers

What is the periodicity of the annual percentage rate in the cash flow yield?

Two (C) Signup and view all the answers

What is the effect of a parallel shift in the yield curve on the bond portfolio's immunization?

It ensures immunization is achieved (B) Signup and view all the answers

Why is it wrong to recommend Portfolio B solely based on its higher yield and closer duration to the investment horizon?

Because the difference in yield is not likely to be significant (D) Signup and view all the answers

What is the desirable property of fixed-income bonds, all else being equal?

Higher convexity (A) Signup and view all the answers

What is the expected outcome at the end of the investment horizon if immunization is achieved?

The bond portfolio's market value will meet or exceed the zero-coupon bond's face value (D) Signup and view all the answers

What is the conclusion that can be drawn about the bond portfolio's market value at the end of the investment horizon?

It will be close to the change in the market value of the zero-coupon bond (B) Signup and view all the answers

What is the client's objective, according to the text?

To minimize the variance in the realized rate of return (D) Signup and view all the answers

Why is Portfolio A recommended over Portfolio B?

Because of its higher convexity (B) Signup and view all the answers

What is the significance of the difference in convexity between the two portfolios?

It is meaningful (D) Signup and view all the answers

What is an implication of implementing the duration-matching strategy at a lower cost?

Investing in less expensive investment-grade bonds (C) Signup and view all the answers

What is the primary reason for choosing Portfolio B over Portfolio A?

Portfolio B has a lower convexity than Portfolio A (A) Signup and view all the answers

What is the goal of immunizing multiple liabilities in a portfolio?

To minimize the structural risk to the strategy (D) Signup and view all the answers

What is the difference between cash flow matching and duration-matching strategies?

Cash flow matching involves buying more expensive government bonds, while duration-matching involves buying less expensive investment-grade bonds (C) Signup and view all the answers

What is the characteristic of a zero-coupon bond that makes it a perfect immunization instrument?

It has a zero dispersion of cash flows (C) Signup and view all the answers

What is the consequence of an immunizing portfolio having a higher convexity than the liabilities?

It increases the structural risk to the strategy (C) Signup and view all the answers