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

A pass-through MBS pool has a weighted average coupon of 6.0% and a pass-through rate of 5.5%. Interest rates in the market fall sharply, and many homeowners refinance. Which statement best describes the effect on an investor holding this pass-through security?

When rates fall, borrowers refinance, so principal is returned early and reinvested at lower yields. The pass-through's price gains are capped, producing negative convexity. Extension of cash flows happens when rates rise, not fall, so the investor clearly faces prepayment risk in the falling-rate scenario.

  1. AThe investor receives principal earlier than expected and must reinvest it at lower rates, and the security's price appreciation is limited (negative convexity)Correct
  2. BThe investor receives principal later than expected, which increases the security's duration and price
  3. CThe investor's coupon rate on the remaining pool balance rises because the remaining borrowers pay higher rates
  4. DThe investor bears no prepayment risk because the pass-through security is backed by mortgage insurance

Explanation

Falling rates raise refinancing, so principal is returned faster and must be reinvested at lower yields. This caps price gains and produces negative convexity. Extension (later principal) occurs when rates rise, not fall, so option B describes the wrong environment.

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