BPS, MBS and prepayment
Hi all,
I studying for an exam and trying to learn about the relationship between MBS , and bps (basis spread point).
Do trader want higher bps or lower? How is this effect with prepayment and duration?
Very helpful thank you
Hey there!
In the world of trading, basis points (bps) are a unit of measure used to describe the percentage change in the value or rate of a financial instrument. One basis point is equivalent to 0.01%.
When it comes to traders, whether they want a higher or lower bps really depends on the situation. If we're talking about yield, a higher bps means the yield is increasing, which is generally good for the trader. However, if we're talking about the cost of a loan, a higher bps means the loan is becoming more expensive, which isn't so great for the trader.
Now, let's talk about Mortgage-Backed Securities (MBS) and prepayment. MBS are a type of investment security that represents a claim on the cash flows from mortgage loans. Prepayment is a risk associated with MBS. When interest rates fall, homeowners might refinance their mortgages, which means they're essentially paying them off early. This can be a problem for MBS investors because they get their principal back sooner than they expected, which means they have to reinvest it at the new, lower interest rates.
Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. If rates rise, the price of the bond falls, and vice versa. The longer the duration, the more sensitive the bond is to interest rate changes.
So, in a nutshell, traders would want a higher bps if it means higher yield, but not if it means higher costs. Prepayment can be a risk for MBS investors, especially in a falling interest rate environment. And duration is a measure of a bond's sensitivity to interest rate changes.
I hope this helps! Let me know if you have any other questions.
Sources: https://www.wallstreetoasis.com/forum/asset-management/sales-trading-interview-guide-gekkos-guidance-part-2?customgpt=1, Math behind pricing a CMBS loan, Bond / fixed income jargon, CDS-Bond Basis - Any credit traders in here?
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