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

Market interest rates fall sharply, and a pass-through security backed by mortgages with coupons well above the new market rate is trading in the market. Which statement best describes the effect on the security's price?

The price rise is limited. Falling rates speed up refinancing and prepayments, so investors get principal back at par sooner and must reinvest at lower yields. This contraction risk causes negative convexity. The agency guarantee protects against credit losses, not against prepayment or interest rate risk.

  1. AIts price rises roughly in line with a comparable non-callable bond because prepayment speeds are unaffected.
  2. BIts price rise is limited because faster prepayments return principal to investors at par when it could only be reinvested at lower rates.Correct
  3. CIts price falls because the servicing fee rises when rates decline.
  4. DIts price is unchanged because the agency guarantee removes all interest rate risk.

Explanation

Borrowers can refinance when rates fall, so prepayments accelerate and investors receive principal at par earlier. This is contraction risk and produces negative convexity, which caps price appreciation. The agency guarantee covers credit risk, not prepayment or interest rate risk.

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