Series 7 practice questionmediumMortgage-Backed Securities — Scenario
An investor holds a GNMA pass-through security yielding 5.5%. Market interest rates drop to 3.5%. The investor faces the GREATEST risk from:
- ADefault on the underlying mortgages
- BIncreased prepayments as homeowners refinance, requiring reinvestment of principal at lower rates✓ Correct answer
- CThe government suspending interest payments
- DExtension of the security's average life
Explanation
Why B — Increased prepayments as homeowners refinance, requiring reinvestment of principal at lower rates
When rates drop from 5.5% to 3.5%, homeowners have a strong incentive to refinance their mortgages at the lower rate. This accelerates prepayments to the GNMA holder, who receives principal back earlier than expected and must reinvest at the lower prevailing rate of 3.5%. Default risk is minimal since GNMA securities carry the full faith and credit guarantee of the US government. Extension risk occurs when rates rise, not fall.
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