Skip to content
Interview prep / Finance/Derivatives

Convexity preference for mortgage bonds in a rally

Question

You hold mortgage-backed securities and expect bond prices to rise sharply (yields to fall). Would you prefer your holdings to have positive or negative convexity?

Short answer

Positive convexity. With positive convexity price gains accelerate as yields fall. MBS usually have negative convexity because falling rates trigger prepayments, which cap price appreciation just when you want it, so in a rally negative convexity costs you.

Adapted from Crack, Heard on the Street, Q2.27, p.28; question and answer rewritten by SelfMadeQuant.com.

See the hint and the full worked solution in the question bank (free account).

Open the worked solution

Lessons behind this question

Start with a free lesson: Expectation, Variance and Covariance is part of a free topic. Create a free account, no card needed, to read it in full with worked solutions.

Read it free