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

A risk manager reviews a pool of 30-year fixed-rate residential mortgages that borrowers may prepay at any time without penalty. Market interest rates fall sharply by 150 basis points. Which outcome is most likely for an investor holding a pass-through security backed by this pool?

Prepayments rise when rates fall because borrowers refinance. The pass-through's expected life shortens and investors get principal back early, capping price appreciation. This is negative convexity, the prepayment option borrowers hold, and it differs from extension risk, which arises when rates rise.

  1. APrepayments rise, shortening the security's expected life and limiting its price appreciation (negative convexity)Correct
  2. BPrepayments fall, lengthening the security's expected life and increasing price appreciation
  3. CPrepayments are unchanged because mortgage cash flows are fixed, so price rises in line with duration
  4. DDefault risk rises sharply because lower rates reduce borrower creditworthiness

Explanation

When rates fall, borrowers refinance, so prepayments speed up and principal is returned early at par when reinvestment yields are lower. This caps price gains and produces negative convexity. Option B describes the behavior when rates rise (extension risk).

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