Measuring MBS Interest Rate Risk
With the exception of cash equivalents, all fixed income investors are exposed to interest rate risk. Interest rate risk is defined as the risk of principal losses due to changes in the level of interest rates. The risks associated with MBS are more difficult to measure than other securities, however. This is because of the incremental risks associated with predicting and measuring prepayment speeds in different interest rate regimes. The two measures of interest rate risk most commonly used by managers are duration and convexity. Duration is a first approximation as to how the value of an individual security or the value of a portfolio will change as interest rates change. Convexity attempts to measure the change in the value of a security or portfolio that is not explained by duration; it is a second approximation of the relationship between a bond’s price and the level of interest rates.
This chapter discusses some of the ways the interest rate risks associated with MBS are measured. The above-mentioned difficulties in measuring risk manifest themselves in a variety of techniques used to calculate duration, as well as additional measures used to gauge the different risks that impact MBS pricing. The chapter also addresses the exposure of MBS to changes in the configuration of the yield curve, as well as other factors that impact the value of a security or portfolio