Question

In assessing interest rate risk for MBS, what two important factors distinguish the concepts of “Average Life” from “Duration” and define each. In addition, a “high-risk mortgage security” is a CMO tranche or pass through that, at the time of purchase or at subsequent testing dates, meets any one of 3 tests. What are the tests as laid out by FFIEC?

Answer 1

Duration is a measure bond's price sensitivity to interest rate changes while average life is the length of time the principal of a debt issue is expected to be outstanding. Duration includes present value of all cash flows including principal as well as interest while average life is the weighted average time to receive principal only.

The three tests laid out by FFIEC are:

1. Average life test : The expected average life of CMO must be less than or equal to 10 years.

2. Average life sensitivity test : The average life of the CMO cannot extend by more than 4 years or shorten by more than 6 years with an immediate shift in the curve of plus minus 300 basis points.

3. Price sensitivity test: The price of the eligible CMO cannot change by more than 17% for an immediate shift in treasury curve of plus or minus 300 basis points.