What is negative convexity, and how does it relate to MBS?
Negative convexity arises due to the prepayment option embedded in MBS. It refers to the disproportionately greater price decline of an MBS compared to a bond with positive convexity when interest rates rise. This occurs because borrowers are more likely to prepay their loans when interest rates fall, resulting in early repayment of MBS and a decrease in their value.