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

A pass-through MBS is trading at a price above par with homeowners holding mortgages whose coupon rates are well above current market mortgage rates. Which statement best describes the security's behaviour when market interest rates fall further?

The MBS price rises by less than a comparable non-callable bond. When rates fall, borrowers refinance and prepay faster, returning principal at par and shortening the security's life. This negative convexity caps price appreciation, even though agency guarantees cover credit risk, not prepayment risk.

  1. AIts price rises roughly in line with a non-callable bond of the same maturity because prepayments are unaffected by rates
  2. BIts price rises by less than a comparable non-callable bond because faster prepayments shorten its life and cap the upsideCorrect
  3. CIts price falls because lower rates reduce the present value of the coupon payments
  4. DIts price is unchanged because principal is guaranteed by the agency

Explanation

Falling rates increase refinancing and prepayments, so principal is returned early at par and the investor must reinvest at lower rates. This is negative convexity, which limits price appreciation. The first option ignores prepayment sensitivity to rates; the third reverses the price-yield relationship.

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