Rob Pirate is considering investing in a subordinated tranche in a collateralized mortgage obligation (CMO). If Pirate wishes to measure his interest rate risk for this debt security, which measure would be most appropriate!
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A. B. C.B
When considering investing in a subordinated tranche of a collateralized mortgage obligation (CMO), Rob Pirate needs to measure the interest rate risk associated with this debt security. The most appropriate measure for this purpose would be the effective duration (Option B).
Effective duration is a key measure used to assess the interest rate risk of fixed-income securities, including mortgage-backed securities like CMOs. It is a measure of the sensitivity of a bond's price (or the value of the debt security) to changes in interest rates.
Here's a detailed explanation of each answer choice:
A. Modified duration: Modified duration is another measure used to assess interest rate risk. It quantifies the percentage change in the price of a bond for a given change in yield. However, modified duration assumes that the cash flows of the bond remain constant, which may not hold true for subordinated tranches of CMOs. Therefore, modified duration may not be the most appropriate measure for assessing interest rate risk in this case.
B. Effective duration: Effective duration, on the other hand, takes into account the potential changes in cash flows that may occur due to prepayments of the underlying mortgage loans in a CMO. As the interest rates change, borrowers may refinance their mortgages, leading to changes in cash flow timing. Effective duration accounts for these potential changes by adjusting the cash flows accordingly. This makes it a more appropriate measure for assessing interest rate risk in CMOs, including subordinated tranches.
C. Effective convexity: Effective convexity is a measure that complements effective duration in assessing interest rate risk. It measures the sensitivity of a bond's duration to changes in interest rates. Convexity takes into account the curvature of the price-yield relationship of a bond, which means it captures the non-linear relationship between price and yield. While effective convexity is an important measure, it is often used in conjunction with effective duration rather than as a standalone measure for assessing interest rate risk.
In summary, when evaluating the interest rate risk associated with a subordinated tranche of a CMO, Rob Pirate should use effective duration (Option B) as the most appropriate measure. Effective duration captures potential changes in cash flows due to prepayments, providing a more accurate assessment of interest rate risk in CMOs compared to modified duration. Effective convexity (Option C) is a complementary measure that can further refine the assessment but is typically used in conjunction with effective duration.