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CFA Level I · CFA Level I Exam · Mortgage-Backed Security (MBS) Instrument and Market Features

A mortgage pass-through investor holds a security backed by fixed-rate mortgages. Market mortgage rates fall sharply, and borrowers refinance in large numbers. The investor's position is best described as being exposed to:

The investor faces contraction risk. Falling mortgage rates prompt refinancing, so prepayments speed up and principal returns sooner than expected, shortening the average life. The investor must then reinvest the cash at lower rates. Extension risk is the reverse and occurs when rates rise and prepayments slow.

  1. Aextension risk, because prepayments slow and the average life of the security lengthens
  2. Bcontraction risk, because prepayments rise and the average life of the security shortensCorrect
  3. Ccredit risk, because refinancing raises the default probability of the remaining borrowers

Explanation

When mortgage rates fall, borrowers refinance and prepay faster, so principal is returned earlier and the security's weighted average life shortens. This is contraction risk. Extension risk arises when rates rise and prepayments slow, which is the opposite situation.

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