The index swap balance is held constant each month, or cashflows from MBS coupon payments and principal payments from MBS amortisations are reinvested in MBS. Hence, investors are insulated from reinvestment risk.
One major retained risk, which mortgage investors hedge by buying interest rate options, is the risk of prepayment by homeowners after declines in mortgage finance rates, which causes MBS values to fall.
“Investors can own the mortgage index with one total-return swap trade without the traditional clearing and settlement issues,” said Alec Crawford, head of MBS and agency research at Deutsche Bank in New York. “We expect the product to be especially attractive to European investors.”