To understand the convexity effect, you must know that when rates go down enough, homeowners refinance their mortgages at lower rates. Those investors who held MBS – or packages (pools) of individual...

To understand the convexity effect, you must know that when rates go down enough, homeowners refinance their mortgages at lower rates. Those investors who held MBS – or packages (pools) of individual home loans or mortgages – experienced a sudden drop in cash flows and, in order to of set this reduction, they are forced to buy T-bonds (such as 10-year ones).