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Agency CMO PO Bonds Trading

Agency CMO PO Bonds Trading

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Published by udo3
Agency Bond Trading
Agency Bond Trading

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Published by: udo3 on Sep 27, 2009
Copyright:Attribution Non-commercial


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Agency CMO PO Bonds TradingBy Udo Onwuachi, BA, MBAQuestion:My traders continue to overpay for PO bonds. Could you please let me know thevariables to use when pricing and trading a PO bond?Answer:There are different types of PO bonds, such as PAC, TAC, SC, SEQ, PT, STP SUP, POor Remics, etc.You must take the following factors into consideration before submitting a bid orasking for a PO bond:• The uncertainty of loan payments due to poor documentation and human error;• Proper hedging instrument;• The number of hedging contracts that you need;• Costs of hedging;• Option;• Past cash flow;• Scaling up prepayment models vectoring out the PSA/CPR with emphasis on keyattributes, modified duration, effective duration, average life and convexityusing YB, Bloomberg or INTEX;• Forecasting payments given inflation, mortgage services fees and loan balances;• Is the collateral backed by GNMA, FNMA, FHLMC or a private label (whole loanCMO)?PO(A) PO(B) PO(C)PSA: 90% Base 110%CPN WAVG: 5.94 8.9 5.60CPN SDEV: 0.12 0.10 0.11MAT WAVG: 307 311 300Figure 1:PO (A) PO(B) PO(C)Effective Duration: 11.4 20.0 10.50The PO with 20.0 effective duration is the most volatile, so when you bid/ask youneed to know the correct OAS and the forward yields curve, as you can see fromFigure 1 above. The correct way to look at Figure 1 is that as a prop trader thisPO asset class will appreciate or lose 11 to 20% in the event of a 100bps in yieldchange.As a prop trader you want to shock the cash flow and duration; this gives you anidea of where to bid. The goal is to avoid overpaying for a bond and to avoidlosing out on a bid.PO(A) PO(B) PO(C)Duration: 4.0 8.6 3.49

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