CFA Level I · CFA Level I Exam · Fixed-Income Securitization
Mortgage rates fall sharply, and a large share of borrowers in a pass-through pool refinance. Compared with a pool with stable mortgage rates, the investor in the pass-through security is most likely to experience:
The investor faces contraction risk. When mortgage rates fall, borrowers refinance and prepay, so principal is returned earlier than expected and must be reinvested at lower market rates, which limits price appreciation.
- Acontraction risk, with principal returned early and reinvested at lower ratesCorrect
- Bextension risk, with principal returned later than expected
- Cno change in the timing of principal because the coupon is fixed
Explanation
Falling rates speed prepayments, so principal comes back sooner than expected and must be reinvested at lower yields. This is contraction risk. Extension risk arises when rates rise and prepayments slow.
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