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FRM Part II · FRM Exam Part II · Structured Credit Risk

A portfolio manager holds a pass-through mortgage-backed security. Market interest rates fall sharply, and borrowers begin refinancing their mortgages in large numbers. Which outcome is most likely for the pass-through holder?

Prepayments rise when rates fall, because borrowers refinance. The pass-through's average life shortens and principal returns early at lower reinvestment rates, so price appreciation is limited. This negative convexity is the typical behavior of mortgage pass-through securities in a falling-rate environment.

  1. APrepayments rise, shortening the security's average life and limiting its price appreciationCorrect
  2. BPrepayments fall, extending the security's average life and increasing its price appreciation
  3. CDefault rates on the pool rise, leading to losses for senior holders
  4. DCoupon payments to the investor rise because the pool's rates reset higher

Explanation

When rates fall, borrowers refinance, so prepayments rise and principal is returned early. This shortens average life and caps price gains, which is negative convexity. Falling prepayments would occur when rates rise, not fall.

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