Skip to content

CFA Level I · CFA Level I Exam · Mortgage-Backed Security (MBS) Instrument and Market Features

Interest rates fall sharply, and borrowers in a pool of 30-year fixed-rate mortgages refinance in large numbers. For an investor in the pass-through security backed by that pool, the most likely result is:

When rates fall and refinancing surges, prepayments speed up, shortening the pool's average life. This is contraction risk: investors get principal back early and reinvest at lower yields, which also caps the price gain that a falling-rate environment would normally give. Extension risk arises when rates rise.

  1. Aa shortened average life and contraction risk, limiting price appreciationCorrect
  2. Ban extended average life and extension risk, increasing price depreciation
  3. Can unchanged average life because scheduled principal is fixed

Explanation

Falling rates raise prepayments, so principal returns sooner and must be reinvested at lower rates; this is contraction risk. Extension risk occurs when rates rise and prepayments slow. Scheduled principal is only part of the cash flow, so average life does change.

Did you get it right without looking?

One question tells you little. A timed set on Mortgage-Backed Security (MBS) Instrument and Market Features shows your real accuracy, how long you take and where you lose marks.

Practise Mortgage-Backed Security (MBS) Instrument and Market FeaturesFree diagnostic mock

More Mortgage-Backed Security (MBS) Instrument and Market Features questions