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FRM Part I · FRM Exam Part I · Mortgages and Mortgage-Backed Securities

A fixed-rate mortgage pass-through security is trading at a premium. Market interest rates fall sharply, and homeowners begin refinancing at a faster pace. Which statement best describes the effect on the security's price behavior?

Price appreciation is limited. Falling rates speed up prepayments, so principal comes back at par and the expected life shortens. This produces negative convexity, so the pass-through gains less than a non-callable bond of similar duration when rates decline.

  1. AIts price rises roughly in line with a non-callable bond of equal duration because cash flows are fixed
  2. BIts price appreciation is limited because faster prepayments shorten its expected life and return principal at parCorrect
  3. CIts price falls because lower rates reduce the coupon paid to investors
  4. DIts duration lengthens because principal is returned later than expected

Explanation

When rates fall, prepayments rise and principal is returned at par, which caps price gains (negative convexity) and shortens the expected life. A premium pass-through loses value on the premium as principal is repaid at par. Lengthening duration occurs when rates rise (extension), so that option is wrong.

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