Interest-Only (IO) strips created from mortgage-backed securities:

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Question restatement: Interest-Only (IO) strips created from mortgage-backed securities: Options are
1) Increase in value when interest rates fall because prepayments accelerate
2) Behave exactly like regular fixed-income bonds
3) Decrease in value when interest rates fall because prepayments reduce future interest payments the IO holder will receive
4) Are completely unaffected by interest rate changes

Option 1: Increase in value when interest rates fall because prepayments accelerate. This is a common intuition for some mortgage-related securities, but for IO strips the opposite occurs. When rates fall, borrowers refinance or prepay, which cuts into the amount of future interest payments payable to the IO holder. The IO’s cash flows shorten and decrease, leading to a drop, not a rise, in value.

Option 2: Behave exactly like regular fixed-income bonds. IO strips do not behave like standard fixed-rate bonds. They have negative convexity and their value is highly sensitive to prepayment risk. The cash flows of IOs are solely interest payments and are heavily impacted by prepayment speeds, unlike typical bonds which have predictable principal and interest streams determined by the contract.

Option 3: Decrease in value when interest rates fall because prepayments reduce future interest payments the IO holder will receive. This is the core concept: falling rates boost prepayments, which shortens and reduces the stream of interest payments to the IO holder, reducing its value. This option correctly captures the relationship between prepayment risk and IO valuation.

Option 4: Are completely unaffected by interest rate changes. This is incorrect because IO strips are highly sensitive to interest rate movements through prepayment behavior; their value moves as rates change due to changing prepayment speeds and the resulting cash-flow profile.

BU.231.710.51.FA25 The Final Exam

Interest-Only (IO) strips created from mortgage-backed securities:

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