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Subject 1. Time Tranching PDF Download

Prepayment risk encompasses contraction risk and extension risk.

Contraction risk is risk when interest rates decline and prepayments speed up. The timing of a pass-through security's cash flows is shortened.

Contraction risk has two components:

  • Like a callable bond, a pass-through security has negative convexity, due to the borrower's embedded option to prepay. The upside potential is limited for investors.

  • Cash flow must be reinvested at a lower rate than the original contract rate. The reinvestment rate risk is therefore high for pass-through securities.

Note that during contraction, duration drops when rates drop. That is, when interest rates drop, the sensitivity of the bond price to interest rates is dampened.

Extension risk is the risk that when interest rates rise, prepayments will slow. The timing of a pass-through security's cash flows is lengthened.

Extension risk also has two components:

  • Anticipated funds are tied up for a longer period of time than originally expected and therefore cannot be reinvested at the new high rates.

  • As rates rise, the pass-through security declines in value more than a non-callable bond would. This is because the delayed cash flows make the duration (interest rate sensitivity) rise.

Note that during extension, duration rises just when rates rise.

Time tranching in MBS refers to the process of dividing the cash flows generated by a pool of mortgage loans into different tranches based on their maturity or time horizon. Each tranche represents a different portion of the cash flows and has a distinct set of characteristics, including risk and return profiles.

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I passed! I did not get a chance to tell you before the exam - but your site was excellent. I will definitely take it next year for Level II.
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