Suppose that the loans in the collateral pool for a nonagency RMBS deal have a floating rate. What is the risk associated with issued fixed-rate bond classes?
What will be an ideal response?
The inclusion of floating-rate mortgage loans in the collateral pool produces floating rate payments. The fixed-rate payments can be difficult to manage when floating rates fall. The risk revolves around the mismatch between the character of the cash flows for the situation where the loans in the collateral pool for a nonagency RMBS deal have a floating rate and the bond classes are fixed rate. The risk can be handled by interest rate derivatives such as interest rate swaps and interest rate caps. While these are often employed in nonagency RMBS structures, they are not allowed in agency RMBS structures. Sincewe do not cover interest rate derivatives until later chapters, we merely point out for now that they are used when there is a mismatch between the character of the cash flows for the loan pool and the character of the cash payments that must be made to the bond classes.
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