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FRM Part II · FRM Exam Part II · The Investment Function in Financial Services Management

A bank considers adding agency mortgage-backed pass-through securities to its investment portfolio. Mortgage rates have just fallen sharply. Which risk is most directly heightened for these holdings compared with a non-callable Treasury of similar maturity?

Prepayment risk is heightened. After a sharp fall in mortgage rates, borrowers refinance, returning principal early, shortening average life and forcing reinvestment at lower yields. Extension risk arises when rates rise, not fall, so it is not the main concern here.

  1. APrepayment risk, shortening the average life and forcing reinvestment at lower yieldsCorrect
  2. BExtension risk, lengthening the average life as borrowers refinance
  3. CSovereign default risk on the underlying mortgages
  4. DInflation-indexation risk from principal adjustments

Explanation

When rates fall, borrowers refinance and prepay, so principal returns early and must be reinvested at lower yields, which limits price appreciation. Extension risk occurs when rates rise, the opposite case.

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