 |
 |
|
Figure 1: Flattening Effect for new agency pass-throughs |
|
|
Curve as of 08/29/2003 |
Flat Curve
|
|||||||||
| CC Speed | FC Speed | CC & FC Speed | |||||||||
|
FN Coupon*
|
OAS
|
Px | Dur | PSA | CPR |
PSA
|
CPR
|
Px
|
Dur
|
PSA
|
CPR
|
|
5.5
|
40
|
99.26
|
4.76
|
261
|
12.7
|
174
|
8.8
|
99.49
|
3.50
|
261
|
12.7
|
|
5.75
|
40
|
100.46
|
4.45
|
309
|
14.7
|
185
|
9.3
|
100.29
|
3.20
|
309
|
14.7
|
|
6.0
|
40
|
101.56
|
4.11
|
390
|
17.9
|
199
|
10.0
|
101.03
|
2.91
|
390
|
17.9
|
|
6.25
|
40
|
102.56
|
3.77
|
534
|
22.8
|
220
|
11.0
|
101.71
|
2.65
|
534
|
22.8
|
|
6.5
|
40
|
103.46
|
3.43
|
754
|
29.2
|
253
|
12.4
|
102.33
|
2.41
|
754
|
29.2
|
Arbitrage-free valuation is driven by the profile of the "forward-curve" (FC) speeds that, in today's market, are much slower than the "current-curve" (CC) speeds. When the curve becomes flat, the FC speeds will be identical to CC speeds, i.e. will accelerate. Correspondingly, premium instruments will become considerably compressed in prices and durations.
It is not difficult to foresee what will happen with other instruments or features when the curve flattens. IOs and MSRs will lose value drastically whereas POs will gain (with this point in mind, hedging against curve risk must be mandatory in the repertoire of MSR risk managers). Prepay penalty origination (and related security trading) may flourish, as bankers will finally be able to justify a sizable rate break for applicants willing to forfeit their call option.
Does the short end matter?
Let us keep in mind that simple computation of long forward rates
involves shorter rates too. For example, a 7-year zero periodic rate,
3-year forward, [denote it ]
will depend on today's 10-year zero rate [ ]
and 3-year zero rate [ &nb ], that is
* WAM = 360 months for all groups
