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FRM Part II · FRM Exam Part II · The Investment Function in Financial Services Management

A regional bank wants to boost portfolio yield and is considering replacing agency bonds with agency mortgage-backed pass-through securities of similar maturity. Which risk is most distinctive to the pass-through securities and must be assessed before the switch?

Prepayment risk is most distinctive to mortgage pass-throughs. When rates fall, borrowers refinance and return principal early, forcing reinvestment at lower yields and limiting price appreciation, which is negative convexity. Rising rates extend duration. Agency bonds of similar maturity lack this cash flow uncertainty.

  1. APrepayment risk, which creates negative convexity when rates fallCorrect
  2. BAbsence of any credit support from the issuer
  3. CInability to be pledged as collateral in repurchase agreements
  4. DCertainty that cash flows follow a fixed schedule

Explanation

Homeowners refinance when rates fall, so principal returns early and must be reinvested at lower rates, capping price gains (negative convexity); extension risk appears when rates rise. Agency pass-throughs have agency support, can be repoed, and have uncertain, not fixed, cash flows.

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