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

A pool of agency pass-throughs has a 6.00% pass-through coupon, while current mortgage rates have fallen to 4.00%. Relative to a similar pool trading when mortgage rates equal 6.00%, which outcome is most likely?

With mortgage rates well below the 6% coupon, borrowers refinance, so prepayments speed up and the average life shortens. This caps price appreciation, producing negative convexity. The agency guarantee protects against default, not prepayment, so prepayment risk remains.

  1. APrepayment speeds rise, and the price appreciation of the pool is limited (negative convexity)Correct
  2. BPrepayment speeds fall, and the pool's weighted average life lengthens
  3. CPrepayment speeds rise, and the pool's price rises without limit as with a non-callable bond
  4. DPrepayment speeds are unaffected because agency guarantees remove prepayment risk

Explanation

When mortgage rates fall below the coupon, borrowers refinance, so prepayments accelerate and the weighted average life shortens. Because investors get principal back at par when the bond would be most valuable, price gains are capped, which is negative convexity. The agency guarantee covers credit risk, not prepayment risk.

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