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

In a CMO, an interest-only (IO) strip and a principal-only (PO) strip are created from the same mortgage pool. If interest rates fall sharply and prepayments rise, what is the most likely change in the values of the strips?

The IO value falls and the PO value rises. Lower rates speed up prepayments, so the PO gets its principal earlier at lower discount rates, while the IO loses interest income because the outstanding principal balance declines faster.

  1. AIO value rises and PO value falls
  2. BBoth IO and PO values fall
  3. CIO value falls and PO value risesCorrect
  4. DBoth IO and PO values rise

Explanation

Falling rates raise prepayments. The PO receives principal sooner, and that principal is discounted at lower rates, so its value rises. The IO receives interest only on outstanding balance, which shrinks quickly, so total interest received falls and its value drops.

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