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

A portfolio manager holds a pool of fixed-rate residential mortgages that borrowers can prepay without penalty. Market mortgage rates fall sharply by 150 basis points. Which outcome is most consistent with the behavior of the pass-through securities backed by this pool?

Prepayment speeds rise when mortgage rates fall because borrowers refinance. Principal returns sooner, the average life shortens, and price gains are capped. This is negative convexity, the key feature of mortgage pass-throughs. Slower prepayment and longer life occur when rates rise.

  1. APrepayment speeds rise, shortening the average life and limiting price appreciation (negative convexity)Correct
  2. BPrepayment speeds fall, lengthening the average life and increasing price appreciation
  3. CPrepayment speeds are unchanged because mortgage cash flows are fixed by contract
  4. DDefault rates rise sharply, because lower rates reduce the borrowers' incentive to repay

Explanation

When rates fall, borrowers refinance, so prepayments accelerate and principal is returned early at a time when reinvestment yields are lower. This caps the price gain of the pass-through and produces negative convexity. Extension of average life happens when rates rise, not fall.

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