Series 7 practice questionmediumCMOs — Extension Risk
Extension risk for a mortgage-backed security refers to the risk that:
- AThe security's maturity is extended beyond 30 years
- BThe issuer fails to make timely interest payments
- CThe credit quality of the underlying mortgages deteriorates
- DPrepayments slow down when rates rise, extending the average life of the security beyond expectations✓ Correct answer
Explanation
Why D — Prepayments slow down when rates rise, extending the average life of the security beyond expectations
Extension risk occurs when interest rates rise and homeowners are less likely to refinance, causing prepayments to slow down. This extends the average life of the MBS beyond what was originally anticipated. Investors are then locked into a lower-yielding security for a longer period while market rates have increased. Extension risk is essentially the opposite of prepayment risk and is most harmful to holders of companion tranches.
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