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

Which of the following is a recognised limitation of using a single modified duration figure to estimate an MBS's price sensitivity?

Modified duration assumes fixed cash flows, but MBS cash flows change with interest rates because of prepayments, so the sensitivity itself shifts as yields move. This is why effective duration, which reprices under rate shocks with revised prepayment assumptions, is used.

  1. ADuration cannot be computed for any security with monthly cash flows
  2. BDuration assumes cash flows are fixed, but MBS cash flows change with rates through prepayments, so duration itself shifts as yields moveCorrect
  3. CDuration only applies to securities with credit risk
  4. DDuration is always higher for MBS than for a Treasury of equal maturity

Explanation

Modified duration assumes fixed cash flows, whereas MBS cash flows depend on the rate path through prepayments. This is why effective duration, using repricing under shifted yields, is preferred. The other options are false statements: monthly flows are fine, and MBS duration is often lower or extends unpredictably.

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