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

A stripped mortgage-backed security market offers interest-only (IO) and principal-only (PO) strips from the same pool of fixed-rate mortgages. Interest rates fall sharply and prepayments accelerate. What is the most likely effect on the values of the two strips?

The IO strip falls in value and the PO strip rises. Faster prepayments shorten the life of the balance on which interest is paid, hurting the IO, while the PO receives its fixed principal earlier and is discounted at lower rates, so its present value increases.

  1. ABoth IO and PO values fall because prepayments reduce the pool's value
  2. BIO value falls and PO value risesCorrect
  3. CIO value rises and PO value falls
  4. DBoth values rise because lower rates increase discounted cash flows

Explanation

Faster prepayments shrink the outstanding balance, so the stream of interest payments on which the IO depends is cut short and IO value falls. The PO receives its principal sooner, and with lower discount rates its present value rises. The opposite pattern would occur if rates rose and prepayments slowed.

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