RMBS Trading Desk Strategy
An Introduction to Agency MBS Derivatives
October 30, 2006
RMBS Trading Desk Strategy
RMBS Trading Desk Modeling
A mortgage derivative can be defined as a CMO class with leveraged exposure to prepayments on the underlying collateral. The coupon on the class can either befixed (IO, PO) or floating (floater, inverse floater). In this primer, we provide anintroduction to mortgage derivatives whose coupon payments are indexed toLIBOR. Specifically, this primer covers Floaters, Inverse floaters, Inverse IOs,TTIBs, Digital IOs, and Toggle floaters.
Mortgage derivatives offer a wide range of duration, curve shape, and convexityexposures and several types of institutional investors actively participate in thismarket. We present a detailed discussion on the investment rationale and risk characteristics for different MBS derivative products.
is a CMO class whose coupon periodically resets at a specified spreadover a specified index, subject to a cap and a floor. In contrast, an
has a coupon with an inverse linear relationship to its index.
Inverse IO (IIO)
is an interest-only security with a coupon formula similar tothat of an inverse floater. It differs from an inverse floater in that inverse IOs don’treceive any principal payments. Inverse IOs usually offer very high current yieldsand are excellent investment vehicles for investors who believe that interest rateswill remain range-bound and/or believe that the yield curve is likely to steepen.
are securities that typically offer high current yields and are a goodinvestment vehicle for investors who either have a bullish view on interest rates or believe that rates will not back-up significantly. On the other hand,
offer low base case yields but have the potential to offer very highyields if rates were to back up significantly.
are an attractive option for investors willing to take on some LIBOR risk for earning higher spreads. For instance, investors can earn a spread of 125-250 bps over 1-mo LIBOR by investing in toggle floaters versus the 30-50 bps of margintypically offered by most other CMO floaters.
This document is NOT a research report under U.S. law and is NOT a product of a fixed income research department. This documenthas been prepared for Qualified Institutional Buyers, sophisticated investors and market professionals only.To our U.K. clients: this communication has been produced by and for the primary benefit of a trading desk. As such, we do not holdout this piece of investment research (as defined by U.K. law) as being impartial in relation to the activities of this trading desk.Please see the important conflict disclosures that appear at the end of this report for information concerning the role of trading deskstrategists.