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

Interest rates fall sharply and the borrowers in a pool of fixed-rate mortgages with coupons well above the new market mortgage rate refinance in large numbers. Which statement best describes the effect on a pass-through MBS investor holding this pool at a premium price?

Faster prepayments return principal at par, so a premium-priced investor loses the premium early and reinvests at lower rates, cutting realized yield. The price rise as rates fall is capped, which is negative convexity. Agency guarantees protect against default, not prepayment timing.

  1. AFaster prepayments return principal at par, reducing the yield realized below the quoted yield, and the security shows negative convexityCorrect
  2. BFaster prepayments extend the average life, raising price volatility and lifting the realized yield
  3. CPrepayments have no effect on the investor because principal is guaranteed by the agency
  4. DFaster prepayments increase the investor's yield because principal is received sooner

Explanation

A premium-priced pass-through repaid at par loses the premium sooner, and the investor must reinvest at lower rates, so realized yield falls. The price compression as rates fall is negative convexity. Agency guarantees cover credit risk, not prepayment timing, and average life shortens, not extends.

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