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CFA Level I · CFA Level I Exam · Fixed-Income Securitization

A borrower holds a fixed-rate mortgage that allows prepayment without penalty. Market mortgage rates fall well below the borrower's contract rate. The borrower's most likely action, and the effect on the lender, is:

When mortgage rates fall below the contract rate, borrowers are likely to refinance or prepay. The lender gets principal back earlier than scheduled and must reinvest it at lower rates, which is the prepayment risk known as contraction risk.

  1. Ato make only scheduled payments, leaving the lender's cash flows unchanged
  2. Bto refinance or prepay, which returns principal to the lender sooner at lower reinvestment ratesCorrect
  3. Cto extend the loan's term, which raises the lender's interest income

Explanation

When market rates drop, borrowers have an incentive to refinance at the lower rate, so prepayments rise. The lender receives principal early and must reinvest at lower rates, which is contraction risk. The other choices do not describe the typical response.

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