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

A bank's investment portfolio manager is comparing a fixed-rate agency mortgage pass-through security with a non-callable bullet agency bond of similar maturity and coupon. Interest rates fall sharply. Relative to the bullet bond, which outcome is most likely for the pass-through security?

Prepayments would rise as borrowers refinance, shortening the pass-through's effective life and limiting its price gain compared with the non-callable bullet bond. This negative convexity is the prepayment risk that makes mortgage securities underperform when rates fall.

  1. APrepayments rise, shortening its effective life and limiting its price appreciationCorrect
  2. BPrepayments fall, extending its effective life and increasing price appreciation
  3. CIts price rises by more than the bullet bond because of positive convexity
  4. DIts cash flows remain unchanged because the coupon is fixed

Explanation

Homeowners refinance when rates drop, so prepayments accelerate and principal returns early, which must be reinvested at lower rates. This negative convexity caps price gains relative to a bullet bond. Extension risk arises when rates rise, not fall.

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