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

A pass-through is priced at a premium and an investor holds it. Interest rates fall sharply by 150 basis points. Which outcome best describes the effect on this security compared with a non-callable Treasury of similar maturity?

The pass-through's price rises by less than the Treasury's. When rates fall, borrowers refinance and prepay faster, so principal is returned at par, shortening the cash flows and wiping out the premium. This negative convexity limits price appreciation, and the agency guarantee does not cover prepayment risk.

  1. APrice rises by more than the Treasury because faster prepayments extend the pass-through's duration
  2. BPrice rises by less than the Treasury because faster prepayments shorten its cash flows and the premium is lost on prepaid principalCorrect
  3. CPrice falls because lower rates reduce the pass-through rate
  4. DPrice rises by the same amount because agency guarantees remove prepayment risk

Explanation

Falling rates raise prepayments, so principal returns at par and premium holders lose value; cash flows shorten, giving negative convexity and compressed price gains. The guarantee covers credit risk, not prepayment risk. Extension happens when rates rise, not fall.

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