| interest rate | ↑ | ↓ | favorable prepayment | downside risk | convexity |
| prepayment | ↓ | ↑ | |||
| IO price (or return) | ↑ | ↓ | slow | Contraction risk | |
| PO price (or return) | ↓ | ↑ | fast | Extention risk | negative at low current rate |
(Question)
Which of the following statements about interest-only (IO) and principal-only (PO) strips is least accurate?
A. The IO price is positively related to interest rates, and at low current rates, POs exhibit some negative convexity.
B. IO cash flows start out large and diminish over time. As a result, IO investors are most concerned with extention risk.
C. In general, the volatility of the combined IO and PO strips equals the price volatility of the source passthrough.
Answer: B
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