Wednesday, October 29, 2008


Timing For Call Risk.
As explained in the previous post,many bonds contain a provision that allows the issuer to retire,or "call all or part of the issued before the maturity date".This issuer usually retains this right to refinance the bond in the future if market interest rates decline below the coupon rate.
From the investor's perspective,there are three disadvantages of the call provision.
  1. The cash flow pattern of the callable bond is not known with certainty.
  2. The issuer will call the bonds when interest rates have dropped.
  3. The capital appreciation potential of a bond will reduced because the price of a callable bond may not rise much above the price at which the issuer may call the bond.
Many long treasury and agency bonds,most corporate and municipal bonds,and almost all mortgage-backed securities have embedded in them the option on the part of the borrower to call,or terminate the bond before the stated maturity date.Even though the investor is usually compensated for talking the risk of call means of a lower price or a higher yield,it is not easy to determine of this compensation is sufficient.In any case,the returns from a bond with call risk can be dramatically different from those obtained from a non malleable bond.
The magnitude of this risk depends upon the various parameters of the call as well as on market conditions.Timing risk is so pervasive in fixed income portfolio management that many market participants consider it second only to interest rate risk in importance.
In the case of mortgage-backed securities,the cash flow depends or prepayments of principal made by the homeowners in the pool of mortgages that serves as collateral for the security. The timing risk in this case is called prepayment risk.It includes contraction risk-the risk that homeowners will prepay all or part of their mortgages when mortgages interest rates decline.If interest rates rise,however investors would benefit from prepayments.The risk that prepayments will fall down when mortgage interest rate is called extension risk.Thus,timing risk in the case of montage backed securities is called prepayment risk,which included contraction risk and extension risk.

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